Hock P2 2020

Section B - Corporate Finance.

Answers
Section B - Corporate Finance.

1. Question ID: CIA 1191 IV.50 (Topic: Risk and Return)

From the viewpoint of the investor, which of the following securities provides the least
risk?

 A. Income bond.
 B. Mortgage bond.correct
 C. Debenture.
 D. Subordinated debenture.
Question was not answered
Correct Answer Explanation:
A mortgage bond is secured with specific fixed assets, usually real property. Thus,
under the rights enumerated in the bond indenture, creditors will be able to receive
payments from liquidation of the property in case of default. In a bankruptcy proceeding,
these amounts are paid before any transfers are made to other creditors, including
those preferences. Hence, mortgage bonds are less risky than the others listed.
Explanation for Choice A:
An income bond pays interest only if the issuer achieves a certain level of income. Such
bonds are riskier than bonds that carry a stated interest rate because the payment of
interest on income bonds is not guaranteed. An income bond would not have the least
risk among the answer choices.
Explanation for Choice C:
Debenture bonds are unsecured bonds, meaning they are not backed by any specific
asset as collateral. A debenture bond would not have the least risk among the answer
choices.
Explanation for Choice D:
A subordinated debenture is unsecured and has a lower (inferior) claim than other
bonds have on the assets of the company in the event of a bankruptcy. Subordinated
debentures have a claim on the debtor's assets that may be satisfied only after senior
debt has been paid in full. A subordinated debenture would not have the least risk
among the answer choices.
2. Question ID: CIA 589 IV.49 (Topic: Risk and Return)
Which of the following classes of securities are listed in order from lowest
risk/opportunity for return to highest risk/opportunity for return?

 A. U.S. Treasury bonds; corporate first mortgage bonds; corporate income bonds;
preferred stock.correct
 Hock P2 2020
Section B - Corporate Finance.
Answers
 B. Common stock; corporate first mortgage bonds; corporate second mortgage bonds;
corporate income bonds.
 C. Corporate income bonds; corporate mortgage bonds; convertible preferred stock;
subordinated debentures.
 D. Preferred stock; common stock; corporate mortgage bonds; corporate debentures.
Question was not answered
Correct Answer Explanation:
The general principle is that risk and return are directly correlated. U.S. Treasury
securities are backed by the full faith and credit of the federal government and are
therefore the least risky form of investment. However, their return is correspondingly
lower. Corporate first mortgage bonds are less risky than income bonds or stock
because they are secured by specific property. In the event of default, the bondholders
can have the property sold to satisfy their claims. Holders of first mortgages have rights
paramount to those of any other parties, such as holders of second mortgages. Income
bonds pay interest only in the event the corporation earns income. Thus, holders of
income bonds have less risk than shareholders because meeting the condition makes
payment of interest mandatory. Preferred shareholders receive dividends only if they
are declared, and the directors usually have complete discretion in this matter. Also,
shareholders have claims junior to those of debt holders if the enterprise is liquidated.
Explanation for Choice B:
The proper listing among the securities listed is corporate first mortgage bonds,
corporate second mortgage bonds, corporate income bonds and common stock.
Common stock is the riskiest type of instrument.
Explanation for Choice C:
The proper listing among the securities listed is corporate mortgage bonds,
subordinated debentures, corporate income bonds, and convertible preferred stock.
Subordinated debentures are less risky than income bonds and convertible preferred
stock becauase even though subordinated debentures are unsecured debt instruments,
their holders have enforceable claims against the issuer even if no income is earned or
dividends declared.
Explanation for Choice D:
The proper listing among the securities listed is corporate mortgage bonds, corporate
debentures, preferred stock, and common stock. Preferred shareholders receive
preference over common shareholders in an asset distribution in a liquidation and they
generally must receive their dividend before common stockholders receive any
dividend.
3. Question ID: CIA 1192 IV.57 (Topic: Risk and Return)
 Hock P2 2020
Section B - Corporate Finance.
Answers
An investor is currently holding income bonds, debentures, subordinated debentures,
and first-mortgage bonds. Which of these securities traditionally is considered to have
the least risk?

 A. Subordinated debentures.
 B. Income bonds.
 C. First-mortgage bonds.correct
 D. Debentures.
Question was not answered
Correct Answer Explanation:
A mortgage bond is secured with specific fixed assets, usually real property. Thus,
under the rights enumerated in the bond indenture, creditors will be able to receive
payments from liquidation of the property in case of default. In a bankruptcy proceeding,
these amounts are paid before any transfers are made to other creditors, including
those preferences. Hence, mortgage bonds are less risky than the others listed.
Explanation for Choice A:
A subordinated debenture is unsecured and has a lower (inferior) claim than other
bonds have on the assets of the company in the event of a bankruptcy. Subordinated
debentures have a claim on the debtor's assets that may be satisfied only after senior
debt has been paid in full. A subordinated debenture would not have the least risk
among the answer choices.
Explanation for Choice B:
An income bond pays interest only if the issuer achieves a certain level of income. Such
bonds are riskier than bonds that carry a stated interest rate because the payment of
interest on income bonds is not guaranteed. An income bond would not have the least
risk among the answer choices.
Explanation for Choice D:
Debenture bonds are unsecured bonds, meaning they are not backed by any specific
asset as collateral. A debenture bond would not have the least risk among the answer
choices.
4. Question ID: CIA 1187 IV.66 (Topic: Risk and Return)
A measure that describes the risk of an investment project relative to other investments
in general is the

 A. Expected return.
 B. Standard deviation.
 C. Coefficient of variation.
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Section B - Corporate Finance.
Answers
 D. Beta coefficient.correct
Question was not answered
Correct Answer Explanation:
The required rate of return on equity capital in the capital asset pricing model is the risk-
free rate (determined by government securities), plus the product of the market risk
premium times the beta coefficient (beta measures the firm's risk). The market risk
premium is the amount above the risk-free rate that will induce investment in the
market. The beta coefficient of an individual stock is the correlation between the
volatility (price variation) of the stock market and that of the price of the individual stock.
For example, if an individual stock goes up 15% and the market only 10%, the stock's
beta is 1.5. For this reason, beta is a measure that describes the risk (volatility) of an
investment project relative to other investments in general (the market).
Explanation for Choice A:
The expected return of an investment is the weighted average of all of the possible
investment returns, with the probabilities of each return occurring serving as the
weights. It is not a measure that describes the risk of an investment relative to other
investments in general.
Explanation for Choice B:
The standard deviation of the probable expected future returns of an investment is
the absolute measure of the investment's risk. It is not a measure that describes the
risk of an investment relative to other investments in general.
Explanation for Choice C:
The coefficient of variation compares risk with expected return (standard deviation
expected return).
5. Question ID: HOCK CMA P2 SDV1 (Topic: Risk and Return)
New Company's sales and profits are growing rapidly, and so is its dividend. Its dividend
is growing at an annual rate of 25%. This growth in the dividend is expected to continue
for two years. After that, the rate of growth is expected to slow down to 10% per year.
The investors' required rate of return on the stock is 16%. The next annual dividend is
expected to be $1.00. The beta of New Company's stock is 1.5. The U.S. Treasury bill
rate is 4%.
What is the expected market rate of return?

 A. 16.0%
 B. 10.67%
 C. 12.0%correct
 D. 14.67%
Question was not answered
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Section B - Corporate Finance.
Answers
Correct Answer Explanation:
This answer can be calculated using the information given and the Capital Asset Pricing
Model. The CAPM formula is:
r = rf + β(rm − rf)
All the required information for the model except rm is given in the problem. Since we
have only one unknown, rm, we can solve this equation for rm. Plugging the numbers into
the formula, we get:
0.16 = 0.04 + 1.5(rm − 0.04)
Simplifying and solving for rm:
0.16 = 0.04 + 1.5rm − 0.06
0.16 = −0.02 + 1.5rm
0.18 = 1.5rm
rm = 0.12 or 12.0%
Explanation for Choice A:
16% is the required rate of return for investors' in New Company's stock.
Explanation for Choice B:
10.67% is the New Company investors' required rate of return of 16% divided by 1.5,
the stock's beta.
Explanation for Choice D:
14.67% is New Company investors' required rate of return of 16% divided by 1.5, the
stock's beta, plus the risk-free rate of 4%.
6. Question ID: CIA 1192 IV.48 (Topic: Risk and Return)
The difference between the required rate of return on a given risky investment and that
on a riskless investment is the

 A. Standard deviation.
 B. Beta coefficient.
 C. Risk premium for that security.correct
 D. Coefficient of variation.
Question was not answered
Correct Answer Explanation:
According to the Capital Asset Pricing Model, the required rate of return on a given risky
investment (an equity investment) is the risk-free rate (determined by U.S. government
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Section B - Corporate Finance.
Answers
securities) plus the product of the market risk premium multiplied by the security's beta
coefficient (beta measures the firm's risk). The market risk premium is the amount
above the risk-free rate that will induce investment in the market as a whole. The beta
coefficient of an individual stock is the correlation between the volatility (price variation)
of the stock market and that of the price of the individual stock. Thus the market risk
premium multiplied by the security's beta provides the additional required return to
induce an investor to invest in that security.
Explanation for Choice A:
Because the standard deviation is a measure of the variability of an investment's
returns.
Explanation for Choice B:
Because the beta coefficient measures the sensitivity of the investment's returns to
market volatility.
Explanation for Choice D:
Because the coefficient of variation is the standard deviation of an investment's returns
divided by the mean return.
7. Question ID: HOCK RRI 120 (Topic: Risk and Return)
Consider the following graph:

What is the return to the market according to this graph?

 A. 3%
 B. It is impossible to determine the return to the market from the information given.
 C. 9%
 D. 12%correct
 Hock P2 2020
Section B - Corporate Finance.
Answers
Question was not answered
Correct Answer Explanation:
The return to the market is the market return at the point where beta is 1.0. On a graph
of the Security Market Line, betas are on the horizontal axis and expected returns are
on the vertical axis. At the point where beta is 1.0, the expected return is 12%.
Explanation for Choice A:
3% is the risk-free rate, according to this graph. The risk-free rate is the point where the
Security Market Line intersects the Y axis, where beta is zero.
Explanation for Choice B:
It is not impossible to determine the return to the market from the graph.
Explanation for Choice C:
9% is the market risk premium, according to this graph. The market risk premium is the
difference between the risk-free rate and the return to the market.
8. Question ID: ICMA 10.P2.113 (Topic: Risk and Return)
Which one of the following would have the least impact on a firm's beta value?

 A. Payout ratio.correct
 B. Operating leverage.
 C. Debt-to-equity ratio.
 D. Industry characteristics.
Question was not answered
Correct Answer Explanation:
A firm's beta is a measurement of the investment's risk. A beta over 1.0 means that
historically, the price of the stock has been more volatile than the price of stocks in the
market as a whole, as measured by an index of market activity such as the S&P 500.
The dividend payout ratio measures the percentage of earnings paid to stockholders as
dividends in the past. A firm's dividend payout ratio would not have much impact on its
beta.
Explanation for Choice B:
A firm's beta is a measurement of the investment's risk. A beta over 1.0 means that
historically, the price of the stock has been more volatile than the price of stocks in the
market as a whole, as measured by an index of market activity such as the S&P 500.
Operating leverage is a reflection of the proportion of fixed operating costs a company
has relative to its variable operating costs. High fixed costs and high operating leverage
create risk because a small decrease in sales volume can lead to a large decrease in
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Section B - Corporate Finance.
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operating income. Therefore, the proportion of fixed costs a company has relative to its
variable costs impacts its beta.
Explanation for Choice C:
A firm's beta is a measurement of the investment's risk. A beta over 1.0 means that
historically, the price of the stock has been more volatile than the price of stocks in the
market as a whole, as measured by an index of market activity such as the S&P 500.
The amount of debt a company has as a proportion of its total capital is an indication of
the risk incurred by a company, because debt must be repaid, whereas equity does not
have to be repaid. Higher debt as a proportion of total capital is an indication of greater
risk in the investment, because if revenues decline, the debt may not be able to be
repaid. And lower debt is an indication of lower risk. The risk will be reflected in the
firm's beta value.
Explanation for Choice D:
Beta measures the risk of a particular stock as it compares to the market. A beta over
1.0 means that historically, the price of the stock has been more volatile than the price
of stocks in the market as a whole, as measured by an index of market activity such as
the S&P 500.
The characteristics of an industry can indicate risk. If the industry is inherently risky,
even the most solid company will have a risk level higher than the market as a whole.
9. Question ID: HOCK RRI 96 (Topic: Risk and Return)
All of the following are true about the beta coefficient except

 A. The beta coefficient of an investment measures how sensitive the stock's return is to
changes in the market's return.
 B. The beta coefficient is the slope of the regression line that relates the return of an
individual security to the return of its benchmark index.
 C. The beta coefficient measures non-market risk.correct
 D. The beta coefficient is used to measure a stock's market risk.
Question was not answered
Correct Answer Explanation:
The beta coefficient measures market, or systematic, risk. It does not measure non-
market risk.
Explanation for Choice A:
This statement is true. The beta coefficient measures the average variability of a stock's
rate of return relative to the market return.
Explanation for Choice B:
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Section B - Corporate Finance.
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This statement is true.
Explanation for Choice D:
This statement is true. The beta coefficient represents the correlation between the
expected return of a given stock and the expected return of the average stock in the
market as represented by some index of market activity such as the S & P 500.
10. Question ID: HOCK RRI 97 (Topic: Risk and Return)
The slope of a Security Market Line is

 A. the market risk premium.correct

 B. the graphical representation of the security's risk.
 C. the graphical representation of the security's returns.
 D. the beta.
Question was not answered
Correct Answer Explanation:
Investors require a higher expected return for a stock with a higher beta. The Security
Market Line tells us what investors’ required rates of return are at each level of risk as
measured by the stock's beta. It shows the linear relationship between the possible beta
coefficients for an individual investment and the required rate of return for the
investment. On an SML graph, the possible betas are on the x axis, and investors'
required rates of return are on the y axis. The slope of a stock's Security Market Line
is the market risk premium, which is RM − RF. The graph of the Capital Asset Pricing
Model equation is a firm's Security Market Line.
Because the required rate of return by investors is a firm's cost of capital, the firm's cost
of equity capital will increase as its stock's beta increases. The Security Market Line for
an individual stock can be used to estimate the firm's cost of debt capital and equity
capital, based on investors’ required rates of return at each level of risk as measured by
the stock's beta.
Explanation for Choice B:
The Security Market Line tells us what investors' required rates of return are at each
level of risk as measured by the stock's beta. However, the slope of a stock's Security
Market Line is not the graphical representation of the security's risk.
Explanation for Choice C:
The graph of the Capital Asset Pricing Model equation is a firm's Security Market Line.
However, the slope of a stock's Security Market Line is not the graphical
represenetation of the security's returns.
Explanation for Choice D:
 Hock P2 2020
Section B - Corporate Finance.
Answers
The Security Market Line tells us what investors' required rates of return are at each
level of risk as measured by the stock's beta. It shows the linear relationship between
the beta coefficient for an individual investment and the required rate of return for the
investment. However, the slope of a stock's Security Market Line is not the stock's beta,
because the possible betas are on the x axis on the graph.
11. Question ID: CMA 697 1.11 (Topic: Risk and Return)
When purchasing temporary investments, which one of the following best describes the
risk associated with the ability to sell the investment in a short period of time without
significant price concessions?

 A. Interest-rate risk.
 B. Liquidity risk.correct
 C. Financial risk.
 D. Purchasing-power risk.
Question was not answered
Correct Answer Explanation:
Liquidity risk is the possibility that an asset cannot be sold on short notice for its market
value. If an asset must be sold at a high discount, it is said to have a substantial amount
of liquidity risk.
Explanation for Choice A:
Because interest-rate risk is caused by fluctuations in the value of an asset as interest
rates change. Its components are price risk and reinvestment-rate risk.
Explanation for Choice C:
Because financial risk is the risk borne by shareholders, in excess of basic business
risk, that arises from use of financial leverage (issuance of fixed income securities, i.e.,
debt and preferred stock).
Explanation for Choice D:
Because purchasing-power risk is the risk that a general rise in the price level (inflation)
will reduce what can be purchased with a fixed sum of money.
12. Question ID: CIA 1190 IV.51 (Topic: Risk and Return)
The risk that securities cannot be sold at a reasonable price on short notice is called

 A. Interest-rate risk.
 B. Default risk.
 C. Liquidity risk.correct
 D. Purchasing-power risk.
Question was not answered
 Hock P2 2020
Section B - Corporate Finance.
Answers
Correct Answer Explanation:
An asset is liquid if it can be converted to cash on short notice. Liquidity (marketability)
risk is the risk that assets cannot be sold at a reasonable price on short notice. If an
asset is not liquid, investors will require a higher return than for a liquid asset. The
difference is the liquidity premium.
Explanation for Choice A:
Because interest-rate risk is the risk to which investors are exposed because of
changing interest rates.
Explanation for Choice B:
Because default risk is the risk that a borrower will not pay the interest or principal on a
loan.
Explanation for Choice D:
Because purchasing-power risk is the risk that inflation will reduce the purchasing power
of a given sum of money.
13. Question ID: ICMA 10.P2.114 (Topic: Risk and Return)
If Dexter Industries has a beta value of 1.0, then its

 A. volatility is low.
 B. expected return should approximate the overall market's expected return.correct
 C. price is relatively stable.
 D. return should equal the risk-free rate.
Question was not answered
Correct Answer Explanation:
A beta of 1.0 means that historically, the stock of Dexter Industries has moved in
tandem with the market. That would indicate that the expected return for the stock
should approximate the expected return to the overall market.
Explanation for Choice A:
An investment's beta measures the sensitivity of the investment to changes in the
market, i.e., as the market changes how will the price of the investment change. A beta
of 1.0 indicates that historically, Dexter Industries has moved in tandem with the market
and bears the systematic risk of the market. If the market is volatile, this stock will be
just as volatile.
Explanation for Choice C:
An investment's beta measures the sensitivity of the investment to changes in the
market, i.e., as the market changes how will the price of the investment change. A beta
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Section B - Corporate Finance.
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of 1.0 indicates that historically, Dexter Industries has moved in tandem with the market
and bears the systematic risk of the market.
Explanation for Choice D:
The risk-free rate is the rate of return an investor could receive on an investment in a
riskless asset. The Capital Asset Pricing Model indicates that the investor will expect a
return equal to the risk-free rate plus compensation for the risk of the stock. The risk of
the stock is measured by the stock's beta multiplied by the difference between the
return to the market and the risk-free rate.
14. Question ID: HOCK RRI 122 (Topic: Risk and Return)
Consider the following graph:

What is the slope of the Security Market Line?

 A. 4.5%
 B. It is impossible to determine the slope of the Security Market Line from the information
given.
 C. 9%correct
 D. 3%
Question was not answered
Correct Answer Explanation:
The slope of the Security Market Line is the market risk premium. The market risk
premium is the difference between the return to the market and the risk-free rate. It is
also the amount by which the expected return for an individual security or portfolio
increases for each 1 unit increase in the security's or portfolio's beta. For a beta of 0.5,
the expected return is 7.5%. For a beta of 1.5 (1.0 greater), the expected return is
16.5%. The difference, 9%, is the slope of the Security Market Line.
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Section B - Corporate Finance.
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Explanation for Choice A:
4.5% is the amount by which the expected return increases when the beta increases by
0.5. However, the slope of the Security Market Line is the amount by which the
expected return increases when the beta increases by 1.0.
Explanation for Choice B:
It is not impossible to determine the slope of the Security Market Line from the graph.
Explanation for Choice D:
3% is the risk-free rate on this graph.
15. Question ID: ICMA 19.P2.021 (Topic: Risk and Return)
A company that prides itself on its innovation revised an existing popular brand without
conducting sufficient market research. By taking this action, the company exposed itself
to what types of risk?

 A. Credit risk and strategic risk.

 B. Hazard risk and credit risk.
 C. Strategic risk and operational risk.correct
 D. Operational risk and hazard risk.
Question was not answered
Correct Answer Explanation:
By revising a popular product without conducting sufficient market research, the
company risks losing customers and losing brand value by making changes that are not
needed or desired by customers. This demonstrates strategic and operational risk.
Explanation for Choice A:
There is no credit risk in this situation.
Explanation for Choice B:
There is no hazard risk or credit risk in this situation.
Explanation for Choice D:
There is no hazard risk in this situation.
16. Question ID: HOCK RRI 91 (Topic: Risk and Return)
Systematic risk is

 A. the possibility that an investment cannot be sold (converted into cash) for its market
value.
 B. risk that cannot be diversified away by holding securities in a diversified
portfolio.correct
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Section B - Corporate Finance.
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 C. risk that can be diversified away by holding securities in a diversified portfolio.
 D. risk that can be quantified.
Question was not answered
Correct Answer Explanation:
Systematic risk, also called market risk, is risk that cannot be diversified away. It is
created by the fact that economic cycles affect all businesses, and publicly-held
investments are traded in a market that can go up and down with economic news.
Systematic, or market, risk cannot be diversified away, and all investments are subject
to it.
Explanation for Choice A:
The possibility that an investment cannot be sold for its market value is liquidity risk.
Explanation for Choice C:
Systematic risk is not risk that can be diversified away.
Explanation for Choice D:
Systematic risk cannot be quantified. (Quantify means to determine the amount of
something.)
17. Question ID: HOCK RRI 121 (Topic: Risk and Return)
Consider the following graph:

If a stock with a beta of 1.5 has an expected return of 20%, it means that the stock

 A. is riskier than others that provide the same return.

 B. is undervalued by the market.correct
 C. is a good investment.
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Section B - Corporate Finance.
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 D. is overvalued by the market.
Question was not answered
Correct Answer Explanation:
This stock is undervalued by the market. Its expected return is 20%, but the expected
return for other securities with betas of 1.5 is only 16.5%, according to the Security
Market Line. Since its expected return is higher than the expected return of other
securities with the same beta, its price must be lower, relative to its returns, than the
other securities with the same beta. And so it is undervalued by the market.
Any securities or portfolios with expected returns that lie above the Security Market Line
are undervalued, because their expected returns are higher than the point on the
Security Market Line relative to their betas. Any securities or portfolios with expected
returns that lie below the Security Market Line are overvalued, because their expected
returns are lower than the point on the Security Market Line relative to their betas.
Explanation for Choice A:
This stock is, in fact, less risky than others that provide the same return. The Security
Market Line displays the relationship between expected return and beta for average
stocks in the market.
A security with an expected return of 20% would be expected to have a beta of
approximately 1.8 based on the location of the Security Market Line. The point on the
SML that intersects with a return of 20% on the y-axis also intersects with 1.8 on the x-
axis containing the betas. If you drop a vertical line from the 20% point on the Security
Market Line, it will intersect the x-axis at about 1.8.
If the security with an expected return of 20% instead has a beta of 1.5, that security is
less risky than other stocks that provide a 20% return and have the expected betas of
1.8.
Explanation for Choice C:
Whether or not a stock is a good investment depends upon the individual investor. No
stock is a good investment for every investor, nor is any stock a bad investment for
every investor.
Explanation for Choice D:
This stock is not overvalued by the market.
18. Question ID: ICMA 10.P2.110 (Topic: Risk and Return)
The systematic risk of an individual security is measured by the

 A. standard deviation of the security's rate of return.

 B. covariance between the security's returns and the general market.correct
 C. standard deviation of the security's returns and other similar securities.
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Section B - Corporate Finance.
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 D. security's contribution to the portfolio risk.
Question was not answered
Correct Answer Explanation:
Systematic risk is risk that all investments are subject to. It is caused by factors that
affect all assets. Examples would be inflation, macroeconomic instability such as
recessions, major political upheavals and wars. Systematic risk cannot be diversified
away, and so it remains even in a fully diversified portfolio.
Covariance is a measure of the strength of the correlation between two (or more) sets of
random variables. Those two random variables could be the historical returns of two
securities; or they could be the historical returns of an individual security and the
historical returns of the market portfolio.
If an individual security's return has historically moved with the return to the market or
moved with the return to another individual security -- both increasing at the same time
and both decreasing at the same time -- the covariance between the security and the
other security or between the security and the market will be zero or greater than zero.
If one decreases when the other increases or increases when the other decreases, their
covariance will be less than zero. If there is no correlation at all between the two, their
covariance will be zero.
The covariance between a security's return and the return to the market is called the
security's beta.
Explanation for Choice A:
The standard deviation of probable expected future returns of a security measures the
security's total risk. Total risk is the risk of a single asset taken by itself and not set off
against any other investments. It is defined as the variability of the asset's relative
expected returns. The standard deviation of returns measures the dispersion of all the
possible returns about their mean (and the mean is the expected return). The larger the
standard deviation for a particular investment is, the greater the variation among
possible returns is and thus, the riskier the investment is.
Total risk consists of systematic risk and unsystematic risk. Unsystematic risk is risk that
is specific to a particular company or to the industry in which the company operates.
Systematic risk is risk that all investments are subject to. It is caused by factors that
affect all assets. Examples would be inflation, macroeconomic instability such as
recessions, major political upheavals and wars. Systematic risk cannot be diversified
away, and so it remains even in a fully diversified portfolio.
The standard deviation of a security's rate of return measures its total risk, not its
systematic risk.
Explanation for Choice C:
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Section B - Corporate Finance.
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The standard deviation of probable expected future returns of a security measures the
security's total risk. Total risk is the risk of a single asset taken by itself and not set off
against any other investments. It is defined as the variability of the asset's relative
expected returns. The standard deviation of returns measures the dispersion of all the
possible returns about their mean (and the mean is the expected return). The larger the
standard deviation for a particular investment is, the greater the variation among
possible returns is and thus, the riskier the investment is.
This is not a true statement for two reasons. One, the standard deviation of the
security's returns measures the security's total risk, not its risk against any other
investments; and two, the standard deviation measures a security's total risk, not its
systematic risk. Total risk consists of both systematic risk and unsystematic risk.
Unsystematic risk is risk that is specific to a particular company or to the industry in
which the company operates. Systematic risk is risk that all investments are subject to.
It is caused by factors that affect all assets. Examples would be inflation,
macroeconomic instability such as recessions, major political upheavals and wars.
Systematic risk cannot be diversified away, and so it remains even in a fully diversified
portfolio.
Explanation for Choice D:
Systematic risk is risk that all investments are subject to. It is caused by factors that
affect all assets. Examples would be inflation, macroeconomic instability such as
recessions, major political upheavals and wars. Systematic risk cannot be diversified
away, and so it remains even in a fully diversified portfolio. Systematic risk is not
measured by a security's contribution to the portfolio risk.
19. Question ID: ICMA 1603.P2.072 (Topic: Risk and Return)
Based on the assumptions of the Capital Asset Pricing Model, the risk premium on an
investment with a beta of 0.5 is equal to

 A. the risk premium on the market.

 B. twice the risk premium on the market.
 C. the risk-free rate.
 D. half the risk premium on the market.correct
Question was not answered
Correct Answer Explanation:
The risk premium for a particular security is its β(RM – RF), or the beta coefficient for that
particular security multiplied by the market risk premium.
The beta coefficient for the market as a whole is 1.0. If the beta coefficient for a given
security is 0.5, it means the risk premium for that security is half the risk premium for the
market as a whole.
Explanation for Choice A:
 Hock P2 2020
Section B - Corporate Finance.
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The risk premium on an investment with a beta of 0.5 cannot be equal to the risk
premium on the market, as the risk premium on the market is a component in the
calculation of the risk premium for an investment.
The risk premium for a particular security is its β(RM – RF), or the beta coefficient for that
particular security multiplied by the market risk premium.
Explanation for Choice B:
The risk premium for a particular security is its β(RM – RF), or the beta coefficient for that
particular security multiplied by the market risk premium.
The beta coefficient for the market as a whole is 1.0. If the beta coefficient for a given
security is 0.5, the risk premium for that security cannot be twice the risk premium for
the market as a whole.
Explanation for Choice C:
The risk premium on an investment with a beta of 0.5 cannot be equal to the risk-free
rate, as the risk-free rate is only one component in the calculation of the risk premium
for an investment.
The risk premium for a particular security is its β(RM – RF), or the beta coefficient for that
particular security multiplied by the market risk premium.
20. Question ID: ICMA 13.P2.021 (Topic: Risk and Return)
Using the capital asset pricing model (CAPM), determine the expected market risk
premium from the following information.

Beta of Investment A 1.4

Risk-free rate 3.0%
Expected return on Investment A 7.4%

 A. 6.14%.
 B. 8.28%.
 C. 7.43%.
 D. 3.14%.correct
Question was not answered
Correct Answer Explanation:
The capital asset pricing model is
r = rF + β(rM − rF)

Where: r = investors' required rate of return

 Hock P2 2020
Section B - Corporate Finance.
Answers
rF = the risk-free rate
β = the individual stock's beta
rM = the expected return to the market
The expected market risk premium is (rM − rF), or the expected return to the market
minus the risk-free rate. We know the risk-free rate is 0.03, but we do not yet know the
expected return to the market.
The first step in solving this is to calculate rM, and the second step is to subtract 0.03,
the rF given in the problem, from the calculated rM to find the expected market risk
premium.
Putting the numbers we know into the CAPM, we solve for rM:
0.074 = 0.03 + 1.4(rM − 0.03)
Steps to solve this using algebra are:
1. Simplify the right side of the equation by performing the multiplication: 0.074 = 0.03 +
1.4rM − 0.042
2. Combine like terms on the right side of the equation: 0.074 = 1.4rM − 0.012
3. Add 0.012 to both sides of the equation: 0.086 = 1.4rM
4. Divide both sides of the equation by 1.4 to calculate the value of rM: rM = 0.0614
Finally, subtract 0.03, the risk-free rate, from 0.0614, the expected return to the market,
to calculate the expected market risk premium:
0.0614 − 0.03 = 0.0314
Explanation for Choice A:
This is the expected return to the market. It is not the expected market risk premium.
The expected market risk premium is the expected return to the market minus the risk-
free rate.
Explanation for Choice B:
This is the expected return of Investment A divided by the beta of investment A, plus the
risk-free rate. This is not the correct use of the capital asset pricing model.
The capital asset pricing model is
r = rF + β(rM − rF)

Where: r = investors' required rate of return

rF = the risk-free rate
 Hock P2 2020
Section B - Corporate Finance.
Answers
β = the individual stock's beta
rM = the expected return to the market
The expected market risk premium is (rM − rF), or the expected return to the market
minus the risk-free rate. We know the risk-free rate is 0.03, but we do not yet know the
expected return to the market.
The first step in solving this is to calculate rM using the information given in the problem,
and the second step is to subtract 0.03, the rF given in the problem, from the calculated
rM to find the expected market risk premium.
Explanation for Choice C:
This is the sum of the risk-free rate and the expected return on Investment A divided by
the beta of Investment A. This is not the correct use of the capital asset pricing model.
The capital asset pricing model is
r = rF + β(rM − rF)

Where: r = investors' required rate of return

rF = the risk-free rate
β = the individual stock's beta
rM = the expected return to the market
The expected market risk premium is (rM − rF), or the expected return to the market
minus the risk-free rate. We know the risk-free rate is 0.03, but we do not yet know the
expected return to the market.
The first step in solving this is to calculate rM using the information given in the problem,
and the second step is to subtract 0.03, the rF given in the problem, from the calculated
rM to find the expected market risk premium.
21. Question ID: HOCK RRI 8 (Topic: Risk and Return)
What kind of risk can be eliminated by diversification in a portfolio?

 A. Market risk
 B. Portfolio risk
 C. Unsystematic riskcorrect
 D. Systematic risk
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Unsystematic risk is risk that affects only one company or one industry and that is
separate from economic or political factors that affect all securities systematically.
Unsystematic risk can be eliminated in a portfolio through proper diversification.
Explanation for Choice A:
Market risk, or systematic risk, is the risk that changes in a security's price will result
from changes that affect all firms. Market risk, or systematic risk, cannot be eliminated
by diversification in a portfolio. Investors will always be exposed to the uncertainties
of the market, no matter how many stocks they hold.
Explanation for Choice B:
Portfolio risk is the risk of several assets when held in combination. The process of
combining assets in such a way so that risk will be reduced is called diversification.
However, portfolio risk is the risk that remains after the diversifiable risk has been
eliminated through diversification.
Explanation for Choice D:
Systematic risk, or market risk, is the risk that changes in a security's price will result
from changes that affect all firms. Systematic risk, or market risk, cannot be eliminated
by diversification in a portfolio. Investors will always be exposed to the uncertainties
of the market, no matter how many stocks they hold.
22. Question ID: HOCK CMA P2 SDV2 (Topic: Risk and Return)
New Company's sales and profits are growing rapidly, and so is its dividend. Its dividend
is growing at an annual rate of 25%. This growth in the dividend is expected to continue
for two years. After that, the rate of growth is expected to slow down to 10% per year.
The investors' required rate of return on the stock is 16%. The next annual dividend is
expected to be $1.00. The beta of New Company's stock is 1.5. The U.S. Treasury bill
rate is 4%.
What is the risk premium of the market?

 A. 4%
 B. 16%
 C. 12%
 D. 8%correct
Question was not answered
Correct Answer Explanation:
The first step in answering this question is to calculate the expected return to the
market. The return to the market can be calculated using the information given and the
Capital Asset Pricing Model. The CAPM formula is:
r = rf + β(rm − rf)
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Section B - Corporate Finance.
Answers
All the required information for the model except rm is given in the problem. Since we
have only one unknown, rm, we can solve this equation for rm. Plugging the numbers into
the formula, we get:
0.16 = 0.04 + 1.5(rm − 0.04)
Simplifying and solving for rm:
0.16 = 0.04 + 1.5rm − 0.06
0.16 = −0.02 + 1.5rm
0.18 = 1.5rm
rm = 0.12 or 12.0%
The market risk premium is (rm − rf). Therefore, the market risk premium is 0.12 − 0.04,
which is 0.08 or 8%.
Explanation for Choice A:
4% is the risk-free rate. U.S. Treasury securities are usually considered to be risk-free,
and their rate is the risk-free rate.
Explanation for Choice B:
16.0% is the New Company investors' required rate of return.
Explanation for Choice C:
12% is the difference between the New Company's investors' required rate of return
(16%) and the risk-free rate (4%). 12.0% is also the risk premium for New Company's
securities. However, the question asks for the risk premium of the market.
23. Question ID: HOCK RRI 9 (Topic: Risk and Return)
An efficient portfolio is a portfolio that is in the feasible set of portfolios and

 A. its historical returns have been above those of its benchmark for 8 of the last 10 years.
 B. offers the highest possible expected return for a given level of risk or offers the lowest
possible risk for a given level of expected return.correct
 C. offers the highest possible expected return for the lowest possible level of risk.
 D. offers the lowest possible risk for the highest possible expected return.
Question was not answered
Correct Answer Explanation:
An efficient portfolio is defined as one that is in the feasible set of portfolios and either
offers the highest possible expected return for a given level of risk or offers the lowest
possible risk for a given level of expected return.
Explanation for Choice A:
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Section B - Corporate Finance.
Answers
Historical returns as compared to a benchmark are no determinant of an efficient
portfolio.
Explanation for Choice C:
High returns and low risk are not compatible. There is a risk-return tradeoff. For a high
return, an investor must accept a higher level of risk. To get a lower level of risk, an
investor must accept a lower return.
Explanation for Choice D:
Low risk and high returns are not compatible. There is a risk-return tradeoff. For a low
level of risk, an investor must accept a lower return. To get a higher return, an investor
must accept a higher level of risk.
24. Question ID: CIA 1191 IV.60 (Topic: Risk and Return)
The risk of loss because of fluctuations in the relative value of foreign currencies is
called

 A. Multinational beta.
 B. Expropriation risk.
 C. Exchange rate risk.correct
 D. Undiversifiable risk.
Question was not answered
Correct Answer Explanation:
By definition, exchange rate risk is the risk of loss that will result from fluctuations in
foreign currency exchange rates.
Explanation for Choice A:
Technically, there is no such thing as "multinational beta." International beta, also
known as "global beta," is a measure of the systematic risk inherent in an individual
stock, a portfolio of stocks, or any investment in relation to the global market. This is
similar to the beta of an individual stock, which is subject to systematic risk because it is
traded on a domestic market; but international beta is relative to the global market
instead of just the domestic market. International, or global, beta is relevant for a large
multinational corporation that has operations throughout the world because its stock
would be closely correlated with a global equity index.
Explanation for Choice B:
Expropriation risk is the risk that a government will seize the assets of a company
without providing fair market compensation.
Explanation for Choice D:
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Section B - Corporate Finance.
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Undiversifiable risk is the amount of risk that may not be eliminated through the proper
diversification of a portfolio.
25. Question ID: HOCK RRI 112 (Topic: Risk and Return)
The risk-free rate of interest that is used in the Capital Asset Pricing Model and other
investment analyses is

 A. approximately the return on a perfectly diversified portfolio.

 B. approximately the return on high-grade commercial paper.
 C. approximately the return on short-term U.S. Treasury Bills.correct
 D. approximately the return on an FDIC-insured savings account.
Question was not answered
Correct Answer Explanation:
The risk-free rate as used in the Capital Asset Pricing Model and other investment
analyses is approximated by the return on very short-term U.S. Treasury Bills.
Securities issued by the U.S. Government are assumed to be free of default risk; and
very short-term securities are assumed to be free of interest rate risk.
Explanation for Choice A:
A diversified portfolio can minimize risk. However, a diversified portfolio is not a risk-free
portfolio. Risk cannot be completely eliminated by diversifying the holdings in an
investment portfolio. The portfolio will still be subject to systematic risk, which is risk that
cannot be diversified away because it is caused by factors that affect all assets and thus
the market in general. Examples of systematic risk are inflation, macroeconomic
instability such as recessions, major political upheavals and wars.
Explanation for Choice B:
High-grade commercial paper is marketable, unsecured short-term debt that is issued
by large, financially sound companies with solid credit histories and high credit ratings.
However, it is not risk-free, as its repayment is dependent upon the ability of the
company to repay the debt.
Explanation for Choice D:
The U.S. Federal Deposit Insurance Corporation insures deposits in member banks. An
FDIC-insured savings account is a very safe account because of the FDIC insurance.
However, there is no single FDIC-insured savings rate, so banks pay different rates of
interest to their savings depositors. Since there is no single FDIC-insured savings rate,
there is no rate among the rates paid by banks that could serve as the risk-free rate of
interest.
26. Question ID: HOCK RRI 124 (Topic: Risk and Return)
 Hock P2 2020
Section B - Corporate Finance.
Answers
The U.S. Treasury Bill rate is 2%. The expected return on the market is 11%. OPQ
Corp.'s common stock has a beta of 1.2, and its dividends have an expected growth
rate of 2%. What is the stock's expected risk premium?

 A. 13.2%
 B. 10.8%correct
 C. 11%
 D. 9%
Question was not answered
Correct Answer Explanation:
The expected risk premium for a stock (or a portfolio) is the difference between the
expected return on the market and the risk-free rate multiplied by the stock's (or
portfolio's) beta. The expected return on the market minus the risk-free rate multiplied
by the beta is 1.2 × (0.11 − 0.02), which is equal to 0.108 or 10.8%.
Explanation for Choice A:
13.2% is the stock's beta (1.2) multiplied by the expected return on the market (0.11).
However, this is not the stock's expected risk premium.
Explanation for Choice C:
11% is the expected return on the market, but it is not the stock's expected risk
premium.
Explanation for Choice D:
9% is the difference between the expected return on the market and the risk-free rate,
but it is not the expected risk premium.
27. Question ID: HOCK RRI 98 (Topic: Risk and Return)
If the risk-free rate is 4% and the expected return on the market is 9%, the risk premium
for a security with a beta of 0.5 is

 A. 6.5%
 B. 50%
 C. 2.5%correct
 D. 5%
Question was not answered
Correct Answer Explanation:
The risk premium for an individual security is its beta multiplied by the difference
between the return to the market and the risk-free rate. Thus, the security's risk
premium is 0.5(0.09 − 0.04), which is 0.025 or 2.5%.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice A:
6.5% is the average of 4% and 9%. It is not the risk premium for a security with a beta
of 0.5.
Explanation for Choice B:
50% is the percentage equivalent of the security's beta, which is 0.5. The security's beta
is not the risk premium for the security.
Explanation for Choice D:
5% is the risk premium for the market as a whole, which is RM − RF, or (0.09 − 0.04). It is
not the risk premium for a security with a beta of 0.5.
28. Question ID: HOCK CMA P2 SDV3 (Topic: Risk and Return)
New Company's sales and profits are growing rapidly, and so is its dividend. Its dividend
is growing at an annual rate of 25%. This growth in the dividend is expected to continue
for two years. After that, the rate of growth is expected to slow down to 10% per year.
The investors' required rate of return on the stock is 16%. The next annual dividend is
expected to be $1.00. The beta of New Company's stock is 1.5. The U.S. Treasury bill
rate is 4%.
What is the risk premium that investors require to invest in New Company's stock?

 A. 16%
 B. 10%
 C. 4%
 D. 12%correct
Question was not answered
Correct Answer Explanation:
The risk premium required by investors to invest in a company's stock is the difference
between the investors' required rate of return on that stock and the risk-free rate. New
Company's investors' required rate of return is 16%. The U.S. Treasury Bill rate, a proxy
for the risk-free rate, is 4%. Therefore, the risk premium required by investors to invest
in New Company's stock is 16% − 4%, or 12%.
Using the Capital Asset Pricing Model, the investors' required risk premium to invest in a
particular stock is also β(rm − rf).
We can use the Capital Asset Pricing Model to solve this question and prove that 12%
is the correct answer. The CAPM is
r = rf + β(rm − rf)
Using the numbers we have and plugging them into the CAPM equation, we have:
 Hock P2 2020
Section B - Corporate Finance.
Answers
0.16 = 0.04 + [1.5(rm − 0.04)]
If we were going to solve this for the one unknown, which is rm, we would begin by
subtracting 0.04 from both sides of the equation. That would leave us with
0.12 = 1.5(rm − 0.04)
And that is the answer to the question. The right side of the equation is the risk premium
for the particular security. The left side of the equation is the answer to the question:
12%.
Explanation for Choice A:
16% is the rate of return required by investors to invest in New Company's stock.
Explanation for Choice B:
10% is the annual rate of growth in New Company's dividend in two years.
Explanation for Choice C:
4% is the risk-free rate. U.S. Treasury securities are usually considered to be risk-free,
and their rate is the risk-free rate.
29. Question ID: ICMA 1603.P2.073 (Topic: Risk and Return)
Using the capital asset pricing model, an analyst has calculated an expected risk-
adjusted return of 17% for the common stock of a company. The company’s stock has a
beta of 2, and the overall expected market return for equities is 10%. The risk-free
return is 3%. All else being equal, the expected risk-adjusted return for the company’s
stock would increase if the

 A. overall expected market return for equities decreases.

 B. volatility of the company's stock decreases.
 C. risk-free return decreases.correct
 D. beta of the company's stock decreases.
Question was not answered
Correct Answer Explanation:
If the risk-free rate of return decreases while the expected return to the market remains
the same and the stock's beta remains the same, in this situation at least, the investors'
expected rate of return for the stock will increase.
The capital asset pricing model formula is R = RF + β(RM − RF), and if RF decreases, the
difference between RM and RF will increase. When that difference is multiplied by the
stock's beta of 2, it would lead to a higher value for R, the expected return for that stock.
Example: using the amounts given in the question, R equals 17%, as follows.
RF + β(RM − RF) = 0.03 + 2.0(0.10 − 0.03) = 0.17
 Hock P2 2020
Section B - Corporate Finance.
Answers
If we decrease the risk-free rate to 2%, the expected return for this stock becomes
RF + β(RM − RF) = 0.02 + 2.0(0.10 − 0.02) = 0.18
Note that if the stock's beta were 0.5 instead of 2.0, though, decreasing the risk-free
rate from 3% to 2% would result in a decrease in the stock's expected return (from
6.5% to 6%) instead of an increase. So a decrease in the risk-free rate will not
always cause an increase in the expected return for a given stock. In order for the
stock's expected return to increase, the stock's beta needs to be high enough so that it
when it is multiplied by the difference between RM and RF, the increase in the
multiplication product that results from the increase in the difference between those two
values offsets the fact that the RF at the beginning of the formula is lower.
Explanation for Choice A:
All else being equal, the expected risk-adjusted return for the company’s stock would
not increase if the market return for equities decreases. Instead, it would decrease.
Example: using the amounts given in the question, R equals 17%, as follows.
RF + β(RM − RF) = 0.03 + 2.0(0.10 − 0.03) = 0.17
If we decrease the market return from 10% to 9%, the expected return for this stock
becomes
RF + β(RM − RF) = 0.03 + 2.0(0.09 − 0.03) = 0.15
Explanation for Choice B:
If the volatility of the company's stock decreases, the stock's beta will decrease. If the
beta of the company's stock decreases, the expected return for the stock would
decrease, not increase.
Example: using the amounts given in the question, R equals 17%, as follows.
RF + β(RM − RF) = 0.03 + 2.0(0.10 − 0.03) = 0.17
If the volatility of the company's stock decreases and the stock's beta decreases to 0.5,
the expected return for this stock becomes
RF + β(RM − RF) = 0.03 + 0.5(0.10 − 0.03) = 0.065

Explanation for Choice D:

All else being equal, the expected risk-adjusted return for the company’s stock would
not increase if the beta of the company's stock decreases. If the beta of the company's
stock decreases, the expected return for the stock would decrease.
Example: using the amounts given in the question, R equals 17%, as follows.
RF + β(RM − RF) = 0.03 + 2.0(0.10 − 0.03) = 0.17
 Hock P2 2020
Section B - Corporate Finance.
Answers
If we change the beta to 0.5, the expected return for this stock becomes
RF + β(RM − RF) = 0.03 + 0.5(0.10 − 0.03) = 0.065
30. Question ID: HOCK RRI 123 (Topic: Risk and Return)
Consider the following graph:

What is the formula that describes this particular Security Market Line?

 A. r = .03 + .5(.045)
 B. r = .03 + β(.12 − .03)correct
 C. R = (1 / 12) + .045
 D. R = .03 + β
Question was not answered
Correct Answer Explanation:
The Capital Asset Pricing Model formula is the formula for the Security Market Line. The
Capital Asset Pricing Model formula is
r = RF + β(RM − RF)
RF, which is the risk-free rate, is the point where beta is zero. RF on this graph is 3%, or
0.03.
RM, or the return to the market, is the return to the market when beta is 1. At 1 on this
graph, the return is 12%, or 0.12.
Thus, the formula that describes this particular Security Market Line is
r = 0.03 + β(0.12 − 0.03)
Explanation for Choice A:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This does not describe any point on the graph, nor does it describe the line on the
graph.
Explanation for Choice C:
This does not describe any point on the graph, nor does it describe the line on the
graph.
Explanation for Choice D:
This does not describe the line on the graph.
31. Question ID: ICMA 19.P2.022 (Topic: Risk and Return)
A German clothing retailer sells its products mainly online to customers worldwide.
Company management believes that its primary risk relates to problems with its online
website. A secondary risk is exchange rate volatility. Which one of the following best
categorizes the company’s primary risk and secondary risk?

 A. Strategic risk, financial risk.

 B. Hazard risk, operational risk.
 C. Operational risk, hazard risk.
 D. Operational risk, financial risk.correct
Question was not answered
Correct Answer Explanation:
The risk of the website is best categorized as an operational risk and the exchange rate
risk is best categorized as a financial risk.
Explanation for Choice A:
The risk of the website is not a strategic risk, but the exchange rate risk is best
categorized as a financial risk.
Explanation for Choice B:
The risk of the website is best categorized as an operational risk, and not a hazard risk,
and the exchange rate risk is not an operational risk.
Explanation for Choice C:
The risk of the website is best categorized as an operational risk, but the exchange rate
risk is not a hazard risk.
32. Question ID: HOCK RRI 99 (Topic: Risk and Return)
The beta coefficient for the market as a whole

 A. is 1.correct
 B. cannot be determined.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 C. is −1.
 D. is zero.
Question was not answered
Correct Answer Explanation:
The beta coefficient for the market as a whole is always 1.
Explanation for Choice B:
The beta coefficient of the market as a whole can be determined.
Explanation for Choice C:
The beta coefficient for the market as a whole is not −1.
Explanation for Choice D:
The beta coefficient for the market as a whole is not zero.
33. Question ID: CMA 696 1.2 (Topic: L-T Financial Management-Financial
Instruments )
A company's stock was trading rights-on for $50.00, and when it went ex-rights the
market price was $48.00. The subscription price for rights holders is $40.00, and four
rights are required to purchase one share of stock.
The value of a right when the stock was trading ex-rights was

 A. $2.50
 B. $0.40
 C. $2.00correct
 D. $0.50
Question was not answered
Correct Answer Explanation:
The value of a right when the stock is trading ex-rights is the market value of the stock
ex-rights minus the subscription price, divided by the number of rights needed to buy
one new share, as follows.
($48 − $40) ÷ 4 = $2
An alternate method of calculating the value of the right when the stock is trading ex-
rights is to compare the market price of the share when it was selling rights-on with the
market price of the share after it went ex-rights. When the stock was trading rights-on,
its market price was $50, and when the stock went ex-rights, the market price
decreased to $48. The difference is $2. Since the only difference between the rights-on
market price and the ex-rights market price is the value of the right, the right must have
a value of $2.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice A:
This is the market price of the stock rights-on minus the subscription price, divided by
the number of rights needed to buy one new share.
The value of a stock right when the stock is ex-rights is the market value of the
stock ex-rights minus the subscription price, divided by the number of rights needed to
buy one new share.
Explanation for Choice B:
This is the rights-on value of the right if the subscription price is $48.
The value of a stock right when the stock is ex-rights is the market value of the stock ex-
rights minus the subscription price, divided by the number of rights needed to buy one
new share.
Explanation for Choice D:
This is the market price of the stock rights-on minus the market price of the stock ex-
rights, divided by the number of rights needed to buy one share.
The value of a stock right when the stock is ex-rights is the market value of the stock ex-
rights minus the subscription price, divided by the number of rights needed to buy one
new share.
34. Question ID: HOCK CFMQ5 (Topic: L-T Financial Management-Financial
Instruments )
A share has a market price of $2.50. It is expected to be able to pay a steady dividend
of 30 cents per share each year starting in one year's time. There will not be any growth
in dividends. Other things being equal, if the expected dividend goes up to 33 cents:

 A. The share price would go up to $2.53.

 B. The share price would go up to $2.75.correct
 C. The share price would go down to $2.25.
 D. The share price would stay at $2.50.
Question was not answered
Correct Answer Explanation:
If the expected dividend increases, the share price should increase. Because the
amount of the dividend is not expected to change after it increases, this is a perpetual
annuity.
We first need to calculate the current investors' rate of return on this perpetual annuity.
The return is calculated as the annual dividend divided by the market value of the
investment, or $0.30 ÷ $2.50, which is 12%.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Now that we know the investors' required rate of return, we can calculate what the share
price would go up to if the annual dividend goes up to $0.33, a new perpetual annuity.
The equation to solve is $0.33 ÷ X = 0.12. Solving for X, we get a share price of $2.75.
Explanation for Choice A:
This answer is the current share price plus the increase in the dividend. See the correct
answer for an explanation.
Explanation for Choice C:
If the expected dividend increases, the share price should increase.
Explanation for Choice D:
If the expected dividend increases, the share price should increase.
35. Question ID: ICMA 19.P2.076 (Topic: L-T Financial Management-Financial
Instruments )
Which one of the following entities is most likely to assist investors in assessing the
default risk of a specific corporate bond?

 A. Investment banks.
 B. Credit rating agencies.correct
 C. Brokerage firms.
 D. Bond dealers.
Question was not answered
Correct Answer Explanation:
Credit rating agencies assist investors in assessing the default risk of a specific
corporate bond.
Explanation for Choice A:
Investment banks do not assist investors in assessing the default risk of a specific
Explanation for Choice C:
Brokerage firms do not assist investors in assessing the default risk of a specific
corporate bond.
Explanation for Choice D:
Bond dealers do not assist investors in assessing the default risk of a specific
36. Question ID: CMA 695 P1 Q9 (Topic: L-T Financial Management-Financial
Instruments )
In practice, dividends
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. tend to be a lower percentage of earnings for mature firms.
 B. fluctuate more widely than earnings.
 C. usually exhibit greater stability than earnings.correct
 D. are usually set as a fixed percentage of earnings.
Question was not answered
Correct Answer Explanation:
Because of the fact that investors look to dividends as a sign of growth and health of the
company, companies generally do not fluctuate their dividends greatly from one year to
the next as this indicates uncertainty for the company. Therefore, even when income
fluctuates greatly from year to year, the company will probably not change its dividend
by much from one year to the next.
Explanation for Choice A:
More mature firms generally pay a higher percentage of their earnings as a dividend
than less mature firms. This is because the older, more mature firm has less need for
capital investment than a younger firm.
Explanation for Choice B:
Most companies maintain a stable dividend over time which means that dividends
fluctuate less than earnings.
Explanation for Choice D:
Dividends are usually not a set percentage of earnings. If dividends were a set
percentage of earnings, dividends would fluctuate greatly as profits fluctuated and
companies do not like their dividends to fluctuate greatly.
37. Question ID: CMA 695 1.5 (Topic: L-T Financial Management-Financial
Instruments )
If a firm is to be purchased entirely for cash, which of the following items would the
purchaser consider?
I. The incremental future after-tax cash flow from operations
II. Cash paid to the seller's shareholders
III. The present value of the seller's liabilities

 A. I and III.
 B. I, II, and III.correct
 C. I and II.
 D. I.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
All of these items would be considered in the determination of how much to pay for a
business because all of these are in one way or another connected to the future cash
flows of the business.
Explanation for Choice A:
The cash paid to the seller's shareholders would also be considered in the
determination of the purchase price of the company.
Explanation for Choice C:
The present value of the seller's liabilities would also be considered in the determination
of the purchase price of the company.
Explanation for Choice D:
The present value of the seller's liabilities and the cash paid to the sellers' shareholders
would also be considered in the determination of the purchase price of the company.
38. Question ID: CMA 693 1.8 (Topic: L-T Financial Management-Financial
Instruments )
Many states have laws that provide preemptive rights for shareholders. A preemptive
right is when a company must

 A. Give existing shareholders stock warrants equal to their proportionate ownership share
in the company when issuing a new public offering.
 B. Sell shares to existing shareholders equal to their proportionate ownership share in the
company when issuing a new public offering.
 C. Give dividends to the common shareholders first before giving dividends to the
preferred shareholders.
 D. Give existing shareholders the opportunity to maintain their proportionate ownership
share in the company when issuing a new public offering.correct
Question was not answered
Correct Answer Explanation:
Preemptive rights guarantee that existing shareholders will have the opportunity to
purchase the same percentage of a new issuance of stock as they owned of the
company before the new issuance. The stockholder may not have the cash necessary
to purchase these newly issued shares, but they must be given the opportunity to do so,
if they have preemptive rights.
Explanation for Choice A:
Preemptive rights guarantee that existing shareholders will have the opportunity to
purchase the same percentage of a new issuance of stock as they owned of the
company before the new issuance. This does not have to be done through the issuance
of warrants, however.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice B:
Preemptive rights guarantee that existing shareholders will have the opportunity to
purchase the same percentage of a new issuance of stock as they owned of the
company before the new issuance. The stockholder may not have the cash necessary
to purchase these newly issued shares, but they must be given the opportunity to do so,
if they have preemptive rights. If the existing shareholders do not exercise this right, the
shares may be sold to anyone.
Explanation for Choice C:
This is not what a preemptive right is.
39. Question ID: HOCK LTF 112 (Topic: L-T Financial Management-Financial
Instruments )
The current price of Mutts, Inc. stock is $30 per share, and during the current year, the
stock paid a 5% dividend. The stock’s beta is 1.2. The expected return to the market is
9%; and the risk-free rate is 3%. Mutts, Inc.'s cost of retained earnings is 10.2%. What
should the company’s next year’s dividend be?

 A. $1.80 per share

 B. $1.574 per sharecorrect
 C. $1.545 per share
 D. $2.70 per share
Question was not answered
Correct Answer Explanation:
The cost of retained earnings is equal to the investors’ required rate of return. The
problem says that the cost of retained earnings is 10.2%, so the investors' required rate
of return is 10.2%. (You can confirm this by using the Capital Asset Pricing Model and
the stock's beta, the risk-free rate and the return to the market, if you wish. However, it
is not necessary to do so, because the investors' required rate of return is given. The
information on the stock's beta, the risk-free rate and the return to the market are
included as distractors in this problem.)
The current year’s dividend is 5% of the stock price, so the current year’s dividend is
$1.50. We have everything we need for the Dividend Growth Model except for the
growth rate in dividends. To find what next year’s dividend should be, we can use the
Dividend Growth Model, solve for the rate of growth, and then multiply the current year’s
dividend ($1.50) by 1 + the growth rate.
The Dividend Growth Model is (D1 / P0) + G = C, where C is the cost of retained
earnings and the investors’ required rate of return. D1 is next year’s dividend, so it is the
current year’s dividend multiplied by 1 + the dividend growth rate. The growth rate in
dividends is what we need to find.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Letting G be the growth rate in the dividend, the formula will be:
(((1.50 × (1 + G)) / 30) + G = 0.102
((1.50 + 1.50G) / 30) = 0.102 – G
1.50 + 1.50G = 30 × (0.102 − G)
1.50 + 1.50G = 3.06 – 30G
1.50 + 31.5G = 3.06
31.5G = 1.56
G = 0.0495, which is the dividend growth rate
Therefore, next year’s dividend should be $1.50 × (1 + 0.0495), or $1.574 per share.
Explanation for Choice A:
This is the stock price multiplied by the dividend yield rate of 0.05 and multiplied again
by the stock's beta of 1.2. This is not the correct way to calculate next year's dividend.
To calculate next year's dividend, it is necessary to use the Dividend Growth Model and
solve for G, then use that to calculate the next year's dividend.
Explanation for Choice C:
This is the stock price multiplied by the dividend yield rate of 0.05 and multiplied again
by 1 + the risk-free rate of 0.03. This is not the correct way to calculate next year's
dividend.
To calculate next year's dividend, it is necessary to use the Dividend Growth Model and
solve for G, then use that to calculate the next year's dividend.
Explanation for Choice D:
This is the stock price multiplied by the expected return to the market. This is not the
correct way to calculate next year's dividend.
To calculate next year's dividend, it is necessary to use the Dividend Growth Model and
solve for G, then use that to calculate the next year's dividend.
40. Question ID: CMA 1288 1.10 (Topic: L-T Financial Management-Financial
Instruments )
The best advantage of a zero-coupon bond to the issuer is that the

 A. Interest can be amortized annually by the APR method and need not be shown as an
interest expense to the issuer.
 B. Interest can be amortized annually on a straight-line basis but is a non-cash
outlay.correct
 C. Bond requires no interest income calculation to the holder or issuer until maturity.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 D. Bond requires a low issuance cost.
Question was not answered
Correct Answer Explanation:
In a zero-coupon bond the bond is sold at a discount from its face amount. During the
life of the bond, no interest is paid, but at the maturity date the face amount of the Bond
is repaid to the buyer. So, there is no annual interest cash payment for a zero-coupon
bond.
Explanation for Choice A:
The interest expense that is amortized each period must be shown as interest expense
by the issuer.
Explanation for Choice C:
Each period the amount of the discount at the sale of the bond needs to be amortized
so even though there is no cash payment, there is an interest calculation each period.
Explanation for Choice D:
The issuance costs for a zero-coupon bond are no less or more than for any other bond.
41. Question ID: ICMA 10.P2.123 (Topic: L-T Financial Management-Financial
Instruments )
James Hemming, the chief financial officer of a midwestern machine parts
manufacturer, is considering splitting the company’s stock, which is currently selling at
$80.00 per share. The stock currently pays a $1.00 per share dividend. If the split is
two-for-one, Mr. Hemming may expect the post split price to be

 A. greater than $40.00, if the dividend is changed to $0.45 per new share.
 B. less than $40.00, regardless of dividend policy.
 C. greater than $40.00, if the dividend is changed to $0.55 per new share.correct
 D. exactly $40.00, regardless of dividend policy.
Question was not answered
Correct Answer Explanation:
The dividend yield before the split is $1 ÷ $80, or 1.25%. If the stock is split 2-for-1,
each shareholder will have twice as many shares after the split. Normally, the price of a
share of stock after a 2-for-1 split will be exactly 50% of the price before the split,
because there are now twice as many shares outstanding, so the dividend per share
should be 50% of its previous level in order to keep the payout to each shareholder the
same. So if no change is made in the dividend, the dividend will be $0.50 per share, and
the market price per share will become $40. That maintains the same dividend yield rate
for the shareholders: $0.50 ÷ $40 = 1.25%.
 Hock P2 2020
Section B - Corporate Finance.
Answers
In a two-for-one split, if the dividend drops by less than 50%, then the price of a share
after the split should be greater than 50% of its price before the split, because the
stockholder is getting a higher dividend yield and would be willing to pay more for the
stock.
If, instead of paying $0.50 per share in dividends, the dividend is changed to $0.55 per
share, the market price of the stock will adjust so that the same dividend yield rate is
maintained. To calculate what the market price of the stock will adjust to, we let X equal
the new share price:
$0.55 ÷ X = 0.0125.
Solving for X, we get X = $44
So, all other things being equal, the market price of the stock should be expected to
increase to $44 if the dividend is changed to $0.55.
Explanation for Choice A:
Normally, the price of a share of stock after a two-for-one split will be exactly 50% of the
price before the split, because there are twice as many shares outstanding. The
dividend would be expected to be exactly 50% of what it was before the split. If the
dividend is changed to $0.45 per share after the two-for-one split, then the dividend has
dropped. In a two-for-one split, if the dividend drops by more than 50%, then the price of
a share after the split should be less than 50% of its price before the split, in order to
take the change in the dividend into consideration.
Explanation for Choice B:
After a two-for-one split, the price of a share of stock will normally be exactly 50% of the
price before the split, because there are twice as many shares outstanding, if the
dividend is unchanged. An unchanged dividend would be one that is exactly 50% of
what it was before the split. In a 2-for-1 stock split, if the price drops by more than 50%,
a change in the dividend policy might explain the drop. The value of the dividends
needs to be considered as well.
Explanation for Choice D:
This answer does not take into consideration the value of the dividends. Normally, the
price of a share of stock after a two-for-one split will be exactly 50% of the price before
the split, because there are twice as many shares outstanding. If the dividend does not
drop by exactly 50% when the stock is split two-for-one, then the price of a share would
be adjusted to take the change in the dividend into consideration.
42. Question ID: ICMA 10.P2.117 (Topic: L-T Financial Management-Financial
Instruments )
Protective clauses set forth in an indenture are known as

 A. requirements.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 B. covenants.correct
 C. addenda.
 D. provisions.
Question was not answered
Correct Answer Explanation:
Covenants are restrictions on the issuer included in a bond indenture that preserve the
company's financial solvency and thus its ability to repay the debt. They provide
protection to the holder of the bond, so they are known as "protective covenants."
Covenants may include a requirement that the issuer maintain a certain minimum level
of working capital, limitation on capital expenditures, limitation on other indebtedness, or
other requirements.
Explanation for Choice A:
Protective clauses in bond indentures are not called "requirements." This is not a
defined term for a bond indenture.
Explanation for Choice C:
Protective clauses in bond indentures are not called "addenda."
Explanation for Choice D:
The "provisions" of a bond indenture are the terms of the bond. The include the issuer’s
obligations to the bond holders. They may or may not be protective clauses.
43. Question ID: CMA 689 1.8 (Topic: L-T Financial Management-Financial
Instruments )
Which one of the following statements is correct regarding the effect preferred stock has
on a company?

 A. Preferred shareholders' claims take precedence over the claims of common

shareholders in the event of liquidation.correct
 B. The firm's after-tax profits are shared equally by common and preferred shareholders.
 C. Control of the firm is now shared by the common and preferred shareholders, with
preferred shareholders having greater control.
 D. Nonpayment of preferred dividends places the firm in default, as does nonpayment of
interest on debt.
Question was not answered
Correct Answer Explanation:
In the event of a liquidation, the claims of preferred shareholders do have priority over
the claims of common shareholders.
Explanation for Choice B:
 Hock P2 2020
Section B - Corporate Finance.
Answers
The after-tax profits do not need to be shared equally between the preferred and
common shareholders.
Explanation for Choice C:
Preferred shareholders generally are unable to vote so preferred shareholders have
less control over the company than common shareholders, who get to vote.
Explanation for Choice D:
The nonpayment of interest puts the company in default, but the nonpayment of interest
does not put the company into default.
44. Question ID: CMA 693 1.17 (Topic: L-T Financial Management-Financial
Instruments )
Which one of the following characteristics distinguishes income bonds from other
bonds?

 A. By promising a return to the bondholder, an income bond is junior to preferred and

common stock.
 B. The bondholder is guaranteed an income over the life of the security.
 C. Income bonds pay interest only if the issuing company has earned the interest.correct
 D. Income bonds are junior to subordinated debt but senior to preferred and common
stock.
Question was not answered
Correct Answer Explanation:
Income bonds are different from other types of bonds because they pay interest only
when the company achieves a given level of net income. This means that for the holder
of interest bonds, there is a chance that they will not receive interest every year.
Explanation for Choice A:
Income bonds do not promise a return to the bondholder and no bonds are junior to
preferred and common shareholders. All bondholders are senior to both preferred and
common shareholders in the order of priority upon liquidation.
Explanation for Choice B:
Income bonds pay interest only if there are sufficient profits. Therefore, the bondholder
is not guaranteed an income over the life of the bond.
Explanation for Choice D:
Income bondholders and all bondholders for that matter are senior to both preferred and
common shareholders in the order of priority upon liquidation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
45. Question ID: HOCK CFMQ4 (Topic: L-T Financial Management-Financial
Instruments )
A share has a market price of $2.50. It is expected to be able to pay a steady dividend
of 30 cents per share each year starting in one year's time. There will not be any growth
in dividends. The stock's beta is 0.8, and the risk-free rate is 3%. The investors' required
rate of return on the shares is:

 A. 30%
 B. 10.2%
 C. 12.0%correct
 D. 15%
Question was not answered
Correct Answer Explanation:
The stock's beta and the risk-free rate are irrelevant information. The only information
needed to calculate the rate of return on this stock are the annual dividend and the
market value of the stock. Because the amount of the dividend is not expected to
change, this is a perpetual annuity. The return is calculated as the annual dividend
divided by the market value of the investment, or $0.30 ÷ $2.50, which is 12%.
Explanation for Choice A:
This is the amount of the expected annual dividend in cents. It is not the investors'
required rate of return for the stock.
Explanation for Choice B:
This answer results from using the Capital Asset Pricing Model and using the rate of
return on the investment as the return on the market. The Capital Asset Pricing Model is
not needed to calculate the rate of return on this investment.
Explanation for Choice D:
This is the annual dividend divided by the stock price, plus the risk-free rate. The risk-
free rate is not needed to calculate the investors' required rate of return. See correct
answer for an explanation.
46. Question ID: CFM CH19 II.13 (Topic: L-T Financial Management-Financial
Instruments )
The market price of Mulva Corporation's common stock is $60 per share, and each
share gives its owner one subscription right. Four rights are required to purchase an
additional share of common stock at the subscription price of $54 per share.
What is the theoretical value of one share of Mulva common stock when it goes "ex-
rights"?

 A. $59.04
 Hock P2 2020
Section B - Corporate Finance.
Answers
 B. $54.00
 C. $58.50
 D. $58.80correct
Question was not answered
Correct Answer Explanation:
In order to determine the value of one share after it is selling ex-rights, we need to
subtract the value of the right from the price of the share when it was selling rights-on.
The formula for determining the value of one stock right when the price of the stock is
rights-on is

P0 − Pn

Vr =
r+1

Where: Po = The market value of one share with the rights still attached
Pn = The subscription (sales) price of a share
r = The number of rights needed to buy one new share
Vr = The value of one right when the stock is selling rights-on
Putting the information from the question into the formula, we get [($60 − $54) / (4 + 1)].
Solving the formula, we get $1.20 as the value of the right when the share is selling
rights-on. Subtracting this $1.20 from the rights-on price, we get the value of the share
when it is selling ex-rights. So, the value of the share ex-rights is $58.80 ($60 − $1.20).
Explanation for Choice A:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice B:
This is the subscription price. See the correct answer for a complete explanation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice C:
This was calculated using $1.50 as the value of a right while it is attached to the share.
This $1.50 value of a right while it is attached to the share was calculated incorrectly as
the difference between the market price of the stock and the subscription price divided
by the number of rights required to purchase one share. This is not the correct way to
calculate the value of a right while it is attached to the share. The difference between
the market price of the stock and the subscription price should be divided by the number
of rights required to purchase one share + 1.
47. Question ID: ICMA 19.P2.078 (Topic: L-T Financial Management-Financial
Instruments )
Which one of the followings is not a relevant factor that influences the dividend policy of
a firm?

 A. The amount of cash not needed for operations.

 B. The dividend income tax rate.
 C. The available investment projects.
 D. The credit policy of the company.correct
Question was not answered
Correct Answer Explanation:
The credit policy of the firm will not influence the dividend policy of a firm.
Explanation for Choice A:
The amount of cash not needed for operations will influence the dividend policy of a
firm.
Explanation for Choice B:
The dividend income tax rate will influence the dividend policy of a firm.
Explanation for Choice C:
The available investment projects will influence the dividend policy of a firm.
48. Question ID: CMA 688 1.7 (Topic: L-T Financial Management-Financial
Instruments )
Below is a partial Statement of Financial Position for Monosone, Inc.:

Monosone, Inc.
Statement of Financial Position
December 31, Year 1
Total assets $10,000,000
Current liabilities $ 2,000,000
 Hock P2 2020
Section B - Corporate Finance.
Answers
Long-term debt 3,000,000
Common stock (1,000,000 shares authorized,
500,000
100,000 shares outstanding at $5 par value)
Paid-in capital in excess of par 1,600,000
Retained earnings 2,900,000
Total liabilities and shareholder's equity $10,000,000
Expected dividend payments:
December 31, year 2 $2.00
December 31, year 3 $2.10
December 31, year 4 $2.25
Expected selling price on:
December 31, year 4 $25.00
An investor is considering buying Monosone, Inc.'s common stock on January 1, year 2
and anticipates, with reasonable assurance, selling it December 31, year 4 at $25.00
per share. What is the approximate intrinsic value on January 1, year 2 of each share
(rounded to the nearest dollar) when the required rate of return is 10%?

 A. $31.
 B. $30.
 C. $24.correct
 D. $19.
Question was not answered
Correct Answer Explanation:
The intrinsic value of the share may be determined by taking the present value of the
future cash flows (dividends and future sales price). This present value is calculated
using the required rate of return, which here is 10%. The dividends are expected to be
$2.00, $2.10 and $2.25 for each of the next three years and then the share will be sold
at the end of the third year for $25. The present value calculation using Present Value of
$1 factors for 10% for one year, two years, and three years, is:
($2.00 × 0.909) + ($2.10 × 0.826) + ($2.25 × 0.751) + ($25.00 × 0.751) =
$1.818 + $1.735 + $1.690 + $18.775 = $24.02
Explanation for Choice A:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This is the amount of future cash flows from the share, not discounted. To get the
current value of the share, these future cash flows need to be discounted at the required
rate of return.
Explanation for Choice B:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice D:
This is approximately the discounted value of the expected selling price of the share
only. We also need to include the discounted value of the future dividend payments as
well.
49. Question ID: ICMA 10.P2.118 (Topic: L-T Financial Management-Financial
Instruments )
A requirement specified in an indenture agreement which states that a company cannot
acquire or sell major assets without prior creditor approval is known as a

 A. call provision.
 B. protective covenant.correct
 C. warrant.
 D. put option.
Question was not answered
Correct Answer Explanation:
Covenants are restrictions on the issuer included in an indenture that preserve the
company's financial solvency and thus its ability to repay the debt. They provide
protection to the lenders (the bond holders), so they are known as "protective
covenants." One example of a protective covenant is a requirement that the company
cannot acquire or sell major assets without prior approval of the creditor. The purchase
of major assets could endanger the borrower’s current position and working capital. The
sale of major assets could endanger profit generation or revenue creation in addition to
removing assets that the lender could look to for repayment of the loan.
Explanation for Choice A:
 Hock P2 2020
Section B - Corporate Finance.
Answers
A call provision enables the company to pay off (redeem) the bond before its maturity
date, usually at a premium to its face value. It does not prevent the company from
acquiring or selling major assets without prior creditor approval.
Explanation for Choice C:
A warrant may be attached to a bond. When a warrant is attached to a bond, it gives the
owner the option to buy stock in the company. It does not prevent the company from
acquiring or selling major assets without prior creditor approval.
Explanation for Choice D:
A put option in a bond indenture gives the holder of the bond the right to sell, or "put"
the bond back to the issuer prior to the bond's maturity date. A bond with this provision
is called a "putable bond." For example, the indenture may state that the holder may put
the bond after a certain date, at a certain price. If the bond pays an interest rate that is
lower than the market rate, the holders will probably put the bond, get their money back,
and reinvest the funds in something with a higher, market level of return. A put option in
a bond indenture does not prevent the company from acquiring or selling major assets
without prior creditor approval.
50. Question ID: CMA 689 1.6 (Topic: L-T Financial Management-Financial
Instruments )
The equity section of Allen Corporation's statement of financial position is presented as
follows.

Preferred stock ($100 par value) $ 8,000,000

Common stock ($5 par value) 5,000,000
Paid-in capital in excess of par 12,000,000
Retained earnings 6,000,000
Net worth $31,000,000
The common shareholders of Allen Corporation have preemptive rights. If Allen
Corporation issues 200,000 additional shares of common stock at $6 per share, a
current holder of 10,000 shares of Allen Corporation's common stock must be given the
option to buy

 A. 2,000 additional shares.correct

 B. 2,400 additional shares.
 C. 1,667 additional shares.
 D. 500 additional shares.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
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Preemptive rights allow the existing shareholders to purchase the same percentage of a
new issuance that they owned of the outstanding shares prior to the issuance. Before
the new issue of stock, there were 1,000,000 common shares outstanding ($5,000,000
divided by $5 par value per share). This shareholder held 1% of the outstanding shares
(10,000 shares divided by 1,000,000 shares) before the issuance, so they have the right
to purchase 1%, or 2,000 shares, of the new issue.
Explanation for Choice B:
This answer results from three errors caused by using the values of the current and
newly-issued stock in the calculations instead of the number of shares.
Step 1: The first step is to calculate the number of shares currently outstanding. The
number of shares outstanding is the $5,000,000 par value of the currently outstanding
common stock divided by the $5 par value per share. This incorrect answer results in
part from failing to perform this calculation and incorrectly using the $5,000,000 value of
the common stock in the calculation in Step 2.
Step 2: After the number of shares has been calculated, the next step is to divide the
current holder's 10,000 shares by the number of shares currently outstanding (from
Step 1) to find the current holder's percentage of ownership. This answer results from
incorrectly dividing the current holder's 10,000 shares by the $5,000,000 par value of
the common stock.
Step 3: The final step is to multiply the number of newly-issued shares given in the
question by the current holder's percentage of ownership found in Step 2 to find the
number of new shares the current holder must be given the option to buy. This answer
results from incorrectly multiplying the value of the newly issued stock by the incorrect
result of Step 2.
Explanation for Choice C:
This answer results from dividing retained earnings by the par value per share to
calculate the number of common shares outstanding before the new issue of stock. The
number of common shares outstanding is the amount on the common stock line divided
by the par value per share.
Explanation for Choice D:
This answer results from dividing the 10,000 shares owned by the shareholder by the
200,000 new shares to be issued and multiplying the result by the 10,000 shares owned
by the shareholder. The shareholder should be given the option to buy the same
proportion of the new shares to be issued as he holds of the total number of common
shares presently outstanding. Therefore, the divisor in the calculation needs to be the
number of common shares presently outstanding, not the number of new shares to be
issued. Furthermore, the result needs to be multiplied by the number of new shares to
be issued, not by the number of shares currently owned by the shareholder.
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Section B - Corporate Finance.
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51. Question ID: ICMA 1603.P2.063 (Topic: L-T Financial Management-Financial
Instruments )
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 overvalued.correct
 B. $2 overvalued.
 C. $4 undervalued.
 D. $2 undervalued.
Question was not answered
Correct Answer Explanation:
The price/earnings ratio is the market price of a share of common stock divided by the
company's earnings per share. Using the price/earnings ratio as the comparable
valuation method, the fair value of a share of the company's stock is its estimated
earnings per share in the next year multiplied by the average price/earnings ratio for the
industry.
That fair value should be compared with the stock's current market price to determine
whether the stock is currently overvalued or undervalued in the market and by how
much. If the company's stock price is higher than the fair value of the stock, the
company's stock is overvalued. If the company's stock price is lower than the fair value
of the stock, the company's stock is undervalued.
The average price/earnings ratio of companies in the same industry as the beverage
company is 15. Since this company is estimated to earn $2 per share in the next year,
the fair value of a share of this company's stock, based on the average P/E ratio for the
beverage industry, is 15 × $2, or $30. Since the common stock of the company has a
current market price of $34, the beverage company's stock is $4 overvalued.
Explanation for Choice B:
This answer results from comparing the price/earnings ratio of the beverage company
stock with the average price/earnings ratio of companies in the beverage industry. That
is not the amount by which the beverage company's stock is overvalued or undervalued
but rather it is the variance of the company's P/E ratio in comparison with the average
P/E ratio of the industry.
The price/earnings ratio is the market price of a share of common stock divided by the
company's earnings per share. Using the price/earnings ratio as the comparable
valuation method, the fair value of a share of the company's stock is its estimated
 Hock P2 2020
Section B - Corporate Finance.
Answers
earnings per share in the next year multiplied by the average price/earnings ratio for the
industry.
That fair value should be compared with the stock's current market price to determine
whether the stock is currently overvalued or undervalued in the market and by how
much. If the company's stock price is higher than the fair value of the stock, the
company's stock is overvalued. If the company's stock price is lower than the fair value
of the stock, the company's stock is undervalued.
Explanation for Choice C:
The beverage company's stock is overvalued, not undervalued. The price/earnings ratio
is the market price of a share of common stock divided by the company's earnings per
share. Using the price/earnings ratio as the comparable valuation method, the fair value
of a share of the company's stock is its estimated earnings per share in the next year
multiplied by the average price/earnings ratio for the industry.
That fair value should be compared with the stock's current market price to determine
whether the stock is currently overvalued or undervalued in the market and by how
much. If the company's stock price is higher than the fair value of the stock, the
company's stock is overvalued. If the company's stock price is lower than the fair value
of the stock, the company's stock is undervalued.
Explanation for Choice D:
This answer results from comparing the price/earnings ratio of the beverage company
stock with the average price/earnings ratio of companies in the beverage industry. That
is not the amount by which the beverage company's stock is overvalued or undervalued
but rather it is the variance of the company's P/E ratio in comparison with the average
P/E ratio of the industry.
The price/earnings ratio is the market price of a share of common stock divided by the
company's earnings per share. Using the price/earnings ratio as the comparable
valuation method, the fair value of a share of the company's stock is its estimated
earnings per share in the next year multiplied by the average price/earnings ratio for the
industry.
That fair value should be compared with the stock's current market price to determine
whether the stock is currently overvalued or undervalued in the market and by how
much. If the company's stock price is higher than the fair value of the stock, the
company's stock is overvalued. If the company's stock price is lower than the fair value
of the stock, the company's stock is undervalued.
52. Question ID: CFM Sample Q. 10 (Topic: L-T Financial Management-Financial
Instruments )
Rogers Inc. operates a chain of restaurants located in the Southeast. The company has
steadily grown to its present size of 48 restaurants. The board of directors recently
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Section B - Corporate Finance.
Answers
approved a large-scale remodeling of the restaurant, and the company is now
considering two financing alternatives.
The first alternative would consist of

 Bonds that would have a 9% effective annual rate and would net $19.2 million after
flotation costs
 Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4%
flotation cost
 Common stock that would yield $24 million after a 5% flotation cost
The second alternative would consist of a public offering of bonds that would have an
11% effective annual rate and would net $48 million after flotation costs.
Rogers' current capital structure, which is considered optimal, consists of 40% long-term
debt, 10% preferred stock, and 50% common stock. The current market value of the
common stock is $30 per share, and the common stock dividend during the past 12
months was $3 per share. Investors are expecting the growth rate of dividends to equal
the historical rate of 6%. Rogers is subject to an effective income tax rate of 40%.
The interest rate on the bonds is greater for the second alternative consisting of pure
debt than it is for the first alternative consisting of both debt and equity because

 A. The combination alternative carries the risk of increasing dividend payments.

 B. The diversity of the combination alternative creates greater risk for the investor.
 C. The pure debt alternative carries the risk of increasing the probability of default.correct
 D. The pure debt alternative would flood the market and be more difficult to sell.
Question was not answered
Correct Answer Explanation:
As a larger proportion of an entity's capital is provided by debt, the debt becomes riskier
and more expensive. Hence, it requires a higher interest rate.
Explanation for Choice A:
Because the combination alternative maintains the same debt-equity mixture, which
would not warrant a rate increase in the cost of debt or equity.
Explanation for Choice B:
Because the diversity decreases, not increases, risk.
Explanation for Choice D:
Because $50,000,000 is minuscule in the debt markets.
 Hock P2 2020
Section B - Corporate Finance.
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53. Question ID: CMA 689 1.2 (Topic: L-T Financial Management-Financial
Instruments )
Serial bonds are attractive to investors because

 A. investors can choose the maturity that suits their financial needs.correct
 B. all bonds in the issue mature on the same date.
 C. the coupon rate on these bonds is adjusted to the maturity date.
 D. the yield to maturity is the same for all bonds in the issue.
Question was not answered
Correct Answer Explanation:
Serial bonds are an issuance of bonds that have different maturity dates. Therefore,
some of the bonds have a 10 year maturity, some 11 years, some 12 years and so on.
Because of this, investors are able to buy a bond that has the time until maturity that
best suits their needs.
Explanation for Choice B:
Serial bonds do not all mature at the same date.
Explanation for Choice C:
The coupon rate does not depend on whether a bond is a serial bond or a term bond.
Explanation for Choice D:
The bonds within a serial issuance of bonds may have different yields to maturity
because of the fact that the bonds each have a different period of time until maturity.
54. Question ID: ICMA 13.P2.070 (Topic: L-T Financial Management-Financial
Instruments )
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
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Section B - Corporate Finance.
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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.
 B. $10,000,000.
 C. $4,000,000.correct
 D. $1,500,000.
Question was not answered
Correct Answer Explanation:
The price/earnings ratio is the price of one share of a company's stock divided by the
earnings per share of the company. However, the same ratio can be calculated for the
company as a whole and used to value the company. The market value of all the shares
of stock outstanding divided by the company's net income available to common
stockholders is equivalent to the P/E ratio except it is for all the shares of stock
outstanding, not just one share.
In this question, we know the net income available to common stockholders ($200,000),
and we know the target P/E ratio (20, the average P/E ratio of the industry in which the
company operates). The market value of all the shares of stock outstanding (the price of
one share multiplied by the number of shares outstanding) is therefore $200,000 × 20,
or $4,000,000.
Explanation for Choice A:
This is the company's sales multiplied by the industry price/earnings ratio. This is not
the correct way to calculate the market value of a business.
Explanation for Choice B:
This is the company's operating income multiplied by the industry price/earnings ratio.
"Earnings" as used in the price/earnings ratio refers to income available to common
stockholders, or net income in this case.
Explanation for Choice D:
This is the book value of the equity in the company. The market value of a company is
different from its book value.
55. Question ID: CIA 1191 IV.59 (Topic: L-T Financial Management-Financial
Instruments )
Which of the following brings in additional capital to the firm?

 A. Two-for-one stock split.

 B. Conversion of convertible bonds to common stock.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 C. Exercise of warrants.correct
 D. Purchase of option through an option exchange.
Question was not answered
Correct Answer Explanation:
When warrants are exercised the company receives new capital. The amount may be
less than if a share was sold in the open market, but the exercise of the warrant still
brings capital to the company.
Explanation for Choice A:
In a stock split, there is no new capital received by the company making the split.
Explanation for Choice B:
The conversion of convertible bonds does not bring new capital to the company.
"Capital" is long-term debt and equity. Conversion of convertible bonds to common
stock decreases long-term debt and increases equity by the same amount, and no cash
is received in the conversion. Thus, capital in total does not increase when convertible
bonds are converted to common stock.
Explanation for Choice D:
The purchase of an option on an option exchange does not involve the company so no
new capital is brought to the company.
56. Question ID: ICMA 10.P2.073 (Topic: L-T Financial Management-Financial
Instruments )
Morton Starley Investment Banking is working with the management of Kell Inc. in order
to take the company public in an initial public offering. Selected information for the year
just ended for Kell is as follows.

Long-term debt (8% interest rate) $10,000,000

Common equity:
Common stock, 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
If public companies in Kell’s industry are trading at a market to book ratio of 1.5, what is
the estimated value per share of Kell?
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. $13.50.
 B. $21.50.
 C. $16.50.correct
 D. $27.50.
Question was not answered
Correct Answer Explanation:
The first thing to do is to calculate the total equity of Kell, then divide that by the number
of shares outstanding to determine the book value per share. Multiplying the book value
per share by 1.5 gives the estimated value per share of Kell.
Total equity is $33,000,000 ($3,000,000 in common stock plus $24,000,000 in
Additional Paid-In Capital plus $6,000,000 in Retained Earnings).
Par value is $1 per share, and common stock is $3,000,000. Therefore, there are
3,000,000 shares outstanding ($3,000,000 ÷ $1).
Book value per share is $33,000,000 ÷ 3,000,000, which is $11 per share. $11
per share multiplied by 1.5 is $16.50, which is the estimated value per share of Kell.
Explanation for Choice A:
This is the total of capital stock and additional paid-in capital divided by the number of
shares outstanding and then multiplied by 1.5. Book value is total equity, and retained
earnings is a part of equity.
Explanation for Choice B:
This is total equity plus long-term debt divided by the number of shares outstanding and
then multiplied by 1.5. Book value is total equity only. It does not include long-term debt,
which is a liability.
Explanation for Choice D:
This is total assets divided by the number of shares outstanding and then multiplied by
1.5. Book value is total equity, not total assets.
57. Question ID: CMA 697 1.23 (Topic: L-T Financial Management-Financial
Instruments )
All of the following may reduce the coupon rate on a bond issued at par except a

 A. Conversion option.
 B. Call provision.correct
 C. Sinking fund.
 D. Change in rating from Aa to Aaa.
Question was not answered
 Hock P2 2020
Section B - Corporate Finance.
Answers
Correct Answer Explanation:
A call provision is considered to be detrimental by the bondholder because this gives
the issuer the right to retire the bonds at any time prior to maturity. This option will be
exercised if interest rates fall and the issuer is able to find other, cheaper sources of
financing. In this environment, the investor may not be able to find an investment with
the same rate of return. To cover for this increased level of risk, the investor will require
that callable bonds pay a higher rate of interest.
Explanation for Choice A:
A conversion option is considered to be a benefit by the investor because it enables the
investor to convert the bonds to shares if that would be beneficial. Therefore, bonds that
have a conversion feature will be able to issued at a lower interest rate.
Explanation for Choice C:
Investors prefer bonds to have sinking funds since it provides some guarantee that the
bonds will be able to be paid when they mature. Because investors like sinking funds,
bonds with sinking funds will be able to be issued at a lower rate of interest.
Explanation for Choice D:
This change in rating is an increase in the rating, meaning that there is less risk
associated with the bonds. This will enable the issuer to decrease the interest rate of
the bonds.
58. Question ID: ICMA 10.P2.119 (Topic: L-T Financial Management-Financial
Instruments )
Dorsy Manufacturing plans to issue mortgage bonds subject to an indenture. Which of
the following restrictions or requirements are likely to be contained in the indenture?

I. Receiving the trustee's permission prior to selling the property.

II. Maintain the property in good operating condition.
III. Insuring plant and equipment at certain minimum levels.
IV. Including a negative pledge clause.

 A. I, III, and IV only.

 B. I and IV only.
 C. II and III only.
 D. I, II, III and IV.correct
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
All four of the restrictions or requirements are likely to be contained in the indenture.
Receiving the trustee's permission is important if the issuer of the mortgage bond wants
to sell the property, because the property is the collateral for the bond.
The requirement to maintain the property in good condition is important because the
property is the collateral for the bond. If the issuer were to default and the property sold
to satisfy the investors in the bond, the investors want to be certain the property will be
worth enough to cover their investment. If it is not maintained properly, its market value
will decrease and it might not be able to be sold for enough to satisfy the investors in
case of a default.
Insuring the plant and equipment at certain minimum levels would also be required,
because if a fire or other disaster were to occur and destroy the assets securing the
mortgage bond, the investors would have no collateral to back up their investment.
Inclusion of a negative pledge clause would also be likely, because a negative pledge
clause is a covenant in an indenture that states that the corporation will not pledge any
of its assets for other debt, if doing so would give the investors in these bonds less
security.
Explanation for Choice A:
Receiving the trustee's permission is important if the issuer of the mortgage bond wants
to sell the property, because the property is the collateral for the bond.
Insuring the plant and equipment at certain minimum levels would also be required,
because if a fire or other disaster were to occur and destroy the assets securing the
mortgage bond, the investors would have no collateral to back up their investment.
Inclusion of a negative pledge clause would also be likely, because a negative pledge
clause is a covenant in an indenture that states that the corporation will not pledge any
of its assets for other debt, if doing so would give the investors in these bonds less
security.
However, these are not the only restrictions or requirements that are likely to be
contained in the indenture.
Explanation for Choice B:
Receiving the trustee's permission is important if the issuer of the mortgage bond wants
to sell the property, because the property is the collateral for the bond.
Inclusion of a negative pledge clause would also be likely, because a negative pledge
clause is a covenant in an indenture that states that the corporation will not pledge any
of its assets for other debt, if doing so would give the investors in these bonds less
security.
However, these are not the only restrictions or requirements that are likely to be
contained in the indenture.
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Section B - Corporate Finance.
Answers
Explanation for Choice C:
The requirement to maintain the property in good condition is important because the
property is the collateral for the bond. If the issuer were to default and the property sold
to satisfy the investors in the bond, the investors want to be certain the property will be
worth enough to cover their investment. If it is not maintained properly, its market value
will decrease and it might not be able to be sold for enough to satisfy the investors in
case of a default.
Insuring the plant and equipment at certain minimum levels would also be required,
because if a fire or other disaster were to occur and destroy the assets securing the
mortgage bond, the investors would have no collateral to back up their investment.
However, these are not the only restrictions or requirements that are likely to be
contained in the indenture.
59. Question ID: HOCK LTF 111 (Topic: L-T Financial Management-Financial
Instruments )
The price of Investors, Inc. stock is $31.25, and its beta is 1.2. The stock’s next annual
dividend will be $1.25, and dividends are expected to grow at the rate of 5% per year.
The risk-free rate is 3%. What is the expected return to the market?

 A. 8.00%correct
 B. 8.17%
 C. 9.00%
 D. 10.20%
Question was not answered
Correct Answer Explanation:
The first step in solving this is to use the Dividend Growth Model and solve for R to find
the investors' required rate of return for the security. The second step is to use the
Capital Asset Pricing Model to solve for the expected return to the market.
The Dividend Growth Model is:
P0 = D1 / (R − G)
R is the cost of retained earnings for the security, which is also the investors' required
rate of return.
P0, or the price of the stock, is given as $31.25.
G, the growth rate, is given as 5% or 0.05.
D1 is the next dividend to be paid. The problem tells us that the next annual dividend will
be $1.25. It is not necessary to multiply $1.25 by 1 + the growth rate to get the next
 Hock P2 2020
Section B - Corporate Finance.
Answers
dividend because $1.25 is already the next dividend. Therefore, using the Dividend
Growth Model to solve for R, the investors' required rate of return:
31.25 = $1.25 / (R − 0.05)
Multiply both sides of the equation by (R − 0.05) to get the (R − 0.05) out of the
denominator:
31.25 (R − 0.05) = 1.25
31.25R − 1.5625 = 1.25
Add 1.5625 to both sides of the equation to isolate the term containing the unknown on
one side of the equals sign:
31.25R = 2.8125
Divide both sides of the equation by 31.25 to solve for R:
R = 0.09
The formula for the Capital Asset Pricing Model is:
R = RF + β(RM − RF)
Where R is the cost of retained earnings, which is also the investors' required rate of
return.
Using the investors' required rate of return calculated in the first step by means of the
Dividend Growth Model and letting X stand for RM, we can solve the CAPM for RM, or the
return to market, as follows:
0.09 = 0.03 + 1.2(X − 0.03)
0.09 = 0.03 + 1.2X − 0.036
0.096 = 1.2X
X = 0.08 or 8%
Explanation for Choice B:
This answer results from using the wrong amount for the next annual dividend in the
Dividend Growth Model. The problem states that $1.25 is the next annual dividend.
Therefore, that amount does not need to be increased by 1 plus the annual growth rate
to get next year's dividend, because it is already next year's dividend. If the problem had
stated that the dividend amount given was the current year's dividend, it would be
appropriate to multiply it by 1 plus the annual growth rate to get next year's dividend to
use in the Dividend Growth Model.
Explanation for Choice C:
This is the investors' required rate of return. However, the problem asks for the
expected return to the market.
Explanation for Choice D:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This answer results from using the investors' required rate of return in place of the
return to the market in the Capital Asset Pricing Model. The return to the market is what
we are solving for, so that would be represented by an "X" in the CAPM formula.
60. Question ID: ICMA 1603.P2.008 (Topic: L-T Financial Management-Financial
Instruments )
If the yield curve on a term structure of interest rates graph is a flat line with no slope,
which one of the following statements is correct?

 A. The intermediate-term interest rate is lower than the T-bill interest rate.
 B. Long-term rates are the same as short-term rates.correct
 C. Long-term rates are higher than short-term rates.
 D. Bank borrowing rates will rise.
Question was not answered
Correct Answer Explanation:
The term structure of interest rates describes the relationship between interest rates on
bonds and the maturities of the bonds as of a moment in time. The term structure of
interest rates is a graph showing the rates for each different term of bond for bonds
having the same risk characteristics. The various terms (1 month, 3 months, 6 months,
1 year, 2 year, and so forth) are on the X-axis, and the interest rates are on the Y-axis.
Usually, shorter-term bonds have lower yields, because an investor has less risk with a
shorter-yield bond, and so the yield curve will be upsloping with the rates becoming
higher as the bonds' maturities become longer. If the yield curve on a term structure of
interest rates graph is a flat line with no slope, it means that long-term interest rates are
the same as short-term interest rates.
Explanation for Choice A:
The term structure of interest rates describes the relationship between interest rates on
bonds and the maturities of the bonds as of a moment in time. The term structure of
interest rates is a graph showing the rates for each different term of bond for bonds
having the same risk characteristics. The various terms (1 month, 3 months, 6 months,
1 year, 2 year, and so forth) are on the X-axis, and the interest rates are on the Y-axis.
A flat yield curve would not mean that the intermediate-term interest rate is lower than
the T-bill interest rate. Since each term structure of interest rates graph depicts a type of
bonds that have the same risk characteristics but different maturities, such a graph
could not indicate anything about the relationship between two different types of bonds.
Explanation for Choice C:
The term structure of interest rates describes the relationship between interest rates on
bonds and the maturities of the bonds as of a moment in time. The term structure of
interest rates is a graph showing the rates for each different term of bond for bonds
 Hock P2 2020
Section B - Corporate Finance.
Answers
having the same risk characteristics. The various terms (1 month, 3 months, 6 months,
1 year, 2 year, and so forth) are on the X-axis, and the interest rates are on the Y-axis.
A flat yield curve would not depict long-term rates that are higher than short-term rates.
Explanation for Choice D:
The term structure of interest rates describes the relationship between interest rates on
bonds and the maturities of the bonds as of a moment in time. The term structure of
interest rates is a graph showing the rates for each different term of bond for bonds
having the same risk characteristics. The various terms (1 month, 3 months, 6 months,
1 year, 2 year, and so forth) are on the X-axis, and the interest rates are on the Y-axis.
A flat yield curve does not mean that bank borrowing rates will rise. A flat yield curve is
an indication that the market expects that interest rates will not change much in the
future.
61. Question ID: HOCK CFMQ6 (Topic: L-T Financial Management-Financial
Instruments )
A share has a market price of $50.00. It is expected to be able to pay a steady dividend
of $2.50 per share each year starting in one year's time. There will not be any growth in
the dividend. If the investors' required rate of return changes to 8%, the effect would be

 A. there will be no change in either the dividend or the share price.

 B. the dividend would increase to $4.00.
 C. the share price will go up to $62.50.
 D. the share price will go down to $31.25.correct
Question was not answered
Correct Answer Explanation:
The present investors' required rate of return at a share price of $50.00 and an annual
dividend of $2.50 is 5%. Using the perpetual annuity model, it is calculated as $2.50 ÷
$50.00, which is 0.05.
If the investors' required rate of return increases to 8%, the equation to solve to
calculate the new share price is $2.50 ÷ X = 0.08. Solving for X, we get X = $31.25, and
that will be the new share price.
Explanation for Choice A:
The share price will adjust so that purchasers of the stock will receive a return of 8% on
their investment.
Explanation for Choice B:
A stock's dividend does not automatically change just because its investors' required
rate of return changes.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice C:
The current investors' required rate of return for this stock is 5%, calculated as $2.50 ÷
$50.00. If the investors' required rate of return increases to 8%, the price of a share of
stock will go down, not up.
62. Question ID: ICMA 10.P2.125 (Topic: L-T Financial Management-Financial
Instruments )
Preferred stock may be retired through the use of any one of the following except a

 A. conversion.
 B. sinking fund.
 C. call provision.
 D. refunding.correct
Question was not answered
Correct Answer Explanation:
Refunding is the redemption of a bond by raising more funds through another bond that
is issued to pay off the first bond. When a company conducts a refunding operation, it
recalls its existing bonds from the market and sells the new bond. Refunding may be
done because the bonds are nearing maturity or because interest rates have fallen.
Refunding is not an option for the retirement of preferred stock.
Explanation for Choice A:
Some preferred stock carries a provision that allows it to be converted into common
stock. If the preferred stock is converted, it is retired.
Explanation for Choice B:
Preferred stock may provide for a "mandatory" sinking fund with a specific amount to be
set aside each year for retirement of the preferred stock at a specific sinking fund price.
The existence of a Mandatory sinking fund does not mean that the preferred stock
should be reported on the balance sheet as long-term debt, although according to the
SEC, preferred stock with a mandatory sinking fund should be listed ahead of preferred
stock without a mandatory sinking fund.
Explanation for Choice C:
Some preferred stock carries a call provision that allows the company to repurchase the
shares for a specified price or at a specific time. Preferred stock that is repurchased is
retired.
63. Question ID: CMA 1288 1.7 (Topic: L-T Financial Management-Financial
Instruments )
The best reason corporations issue Eurobonds rather than domestic bonds is that:
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. These bonds are denominated in the currency of the country in which they are issued.
 B. Foreign buyers more readily accept the issues of both large and small U.S.
corporations than do domestic investors.
 C. These bonds are normally a less expensive form of financing because of the absence
of government regulation.correct
 D. Eurobonds carry no foreign exchange risk.
Question was not answered
Correct Answer Explanation:
Eurobonds are bonds that are issued in a currency other than the currency of the
country in which they are sold. Since Eurobonds are outside the direct control of the
U.S. monetary authorities, they often have lower costs than domestic bonds because
the cost of regulatory compliance is lower.
Explanation for Choice A:
Eurobonds are not denominated in the currency of the country in which they are issued.
Explanation for Choice B:
While this statement may be true in respect to large, well known companies, individuals
are hesitant to buy bonds of companies that they do not know. Therefore, it may be
hard for a small company to issue bonds in a country other than the one in which it
operates.
Explanation for Choice D:
Eurobonds, and any other item denominated in a foreign currency, carry foreign
exchange risk.
64. Question ID: CMA 693 1.18 (Topic: L-T Financial Management-Financial
Instruments )
The par value of a common stock represents

 A. the total value of the stock that must be entered in the issuing corporation's records.
 B. the liability ceiling of a shareholder when a company undergoes bankruptcy
proceedings.correct
 C. a theoretical value of $100 per share of stock with any differences entered in the
issuing corporation's records as discount or premium on common stock.
 D. the estimated market value of the stock when it was issued.
Question was not answered
Correct Answer Explanation:
The par value of common stock represents the legal capital of the company. This is the
maximum amount that a shareholder can be liable for if the company goes bankrupt.
 Hock P2 2020
Section B - Corporate Finance.
Answers
This is also the amount of capital that may not be distributed as a dividend by the
company. Many companies have a low par value for their shares.
Explanation for Choice A:
The sales price is the amount that must be entered in the issuing company's records for
the sale of stock.
Explanation for Choice C:
This is not what the par value of a share of common stock represents. The par value of
a share of common stock represents the legal capital of the company.
Explanation for Choice D:
The par value of common stock is not related to the estimated market value of the stock
when it was issued.
65. Question ID: CIA 592 IV.48 (Topic: L-T Financial Management-Financial
Instruments )
The maximum acquisition value of an inefficiently run corporation is the discounted net
present value of the

 A. Expected future cash flow.correct

 B. Current earnings before interest and taxes (EBIT).
 C. Current net profits.
 D. Current market value of the firm.
Question was not answered
Correct Answer Explanation:
When determining the acquisition value of anything, the maximum amount to pay is the
present value of the expected future cash flows from whatever is being acquired. When
determining these future cash flows, the potential purchaser will factor in any increases
in sales that will result from the firm being run more efficiently in the future.
Explanation for Choice B:
The current earnings before interest and taxes of a firm that is run inefficiently will be
lower than if it were run efficiently. Therefore, a potential purchaser would be willing to
pay more than the current market value if they believe that they can correct the
inefficiencies.
Explanation for Choice C:
The current net profits of a firm that is run inefficiently will be lower than if it were run
efficiently. Therefore, a potential purchaser would be willing to pay more than the
current market value if they believe that they can correct the inefficiencies.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice D:
The current market value of a firm that is run inefficiently will be lower than if it were run
efficiently. Therefore, a potential purchaser would be willing to pay more than the
current market value if they believe that they can correct the inefficiencies.
66. Question ID: CMA 688 1.11 (Topic: L-T Financial Management-Financial
Instruments )
A sinking fund for a bond issue is a(n)

 A. periodic payment by a debtor to accumulate funds for the retirement of the bonds when
they mature.correct
 B. periodic payment by a debtor to pay the annual interest costs prescribed by the bond
issue.
 C. alternative to traditional long-term debt financing.
 D. periodic payment by a debtor to pay for the initial issuing costs of the bond issue.
Question was not answered
Correct Answer Explanation:
When a bond has a sinking fund requirement, the issuer of the bonds is required to
make periodic contributions to the fund. This fund will be used to repay the face amount
of the bonds when the bonds mature. If there is a sinking fund requirement, the buyers
of the bonds are more comfortable that the bonds will actually be repaid when they
mature. This enables the issuing company to pay a slightly lower interest rate on the
bonds because they are more secure.
Explanation for Choice B:
A sinking fund does require a periodic payment, but the payment is to accumulate
money to repay the face amount when the bond matures. It is not connected to the
payment of bond interest costs.
Explanation for Choice C:
A sinking fund is not a form of financing, but rather a means to accumulate the money
necessary to pay debt as it matures. See the correct answer for a complete explanation.
Explanation for Choice D:
A sinking fund does require a periodic payment, but the payment is to accumulate
money to repay the face amount when the bond matures. It is not connected to the
payment of bond issue costs.
67. Question ID: CMA 691 1.5 (Topic: L-T Financial Management-Financial
Instruments )
Short-term interest rates are
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. Lower than long-term rates during periods of high inflation only.
 B. Usually higher than long-term rates.
 C. Not significantly related to long-term rates.
 D. Usually lower than long-term rates.correct
Question was not answered
Correct Answer Explanation:
Usually short-term interest rates are lower than long-term interest rates. This is due
partially to the fact that there is less risk in a short term situation because there is less
time for something to happen that would prevent the repayment of whatever amount
was financed.
Explanation for Choice A:
During a period of high inflation, short-term interest rates are probably going to be
higher than long-term interest rates.
Explanation for Choice B:
There is less risk in a short term situation because there is less time for something to
happen that would prevent the repayment of whatever amount was financed. Interest
rates incorporate the amount of repayment risk that the investor perceives. The higher
the risk, the higher the rate. Therefore, short-term rates would not usually be higher
than long-term rates.
Explanation for Choice C:
Short-term rates are related to long-term rates, although that relationship can change
from time to time. Term Structure of Interest Rates graphs describe the various
relationships that can exist at any given time between short-term rates and long-term
rates. The yield curve can be upsloping, downsloping, flat, or humped.
Yield curve theories attempt to explain the slopes of the yield curves.

1. The Pure Expectations Theory states that the shape of the yield curve is
determined exclusively by expectations in the market of future interest rates.
2. Liquidity Preference Theory says that if investors increase their risk by holding
long-term bonds, they will require higher compensation in the form of a higher
interest rate for assuming that increased risk.
3. The Segmented Markets Theory focuses on cash needs of different groups of
investors and borrowers and maintains that each group chooses securities that
meet its forecasted cash needs.
4. The Preferred Habitat Theory is a compromise. It agrees with the Segmented
Markets Theory in saying that investors and borrowers normally concentrate on a
particular maturity market. However, it also recognizes, in agreement with the Pure
 Hock P2 2020
Section B - Corporate Finance.
Answers
Expectations Theory, that expectations about future interest rate movements can
cause investors and borrowers to leave their preferred maturity markets for other
maturity markets.
68. Question ID: CMA 693 1.9 (Topic: L-T Financial Management-Financial
Instruments )
The formula for determining the value of one stock right when the price of the stock is
rights-on is

(Pon − S)

Ron =
(N + 1)

Where:
Ron = market value of one right when the stock is selling rights-on.
Pon = market value of one share of stock with rights-on.
N = number of rights necessary to purchase one share of stock.
S = subscription price per share.
If the market price of a stock is $50 per share, the subscription price is $40 per share,
and three rights are necessary to buy an additional share of stock, the theoretical
market value of one right used to buy the stock prior to the ex-rights date is

 A. $2.50.correct
 B. $10.00.
 C. $40.00.
 D. $2.00.
Question was not answered
Correct Answer Explanation:
In order to answer this question, we simply need to put the information in the question
into the formula that is given. Doing this, we get

($50 − $40)

Ron =
(3 + 1)

Solving this formula, we get $2.50 is the value of a right. We can check this as follows:
first let us assume that we have one shareholder who purchased 3 shares for $50,
 Hock P2 2020
Section B - Corporate Finance.
Answers
received 3 rights and then purchased the fourth share for $40. This person will have
spent a total of $190 for four shares, an average of $47.50 per share. A second person
purchased three rights for $2.50 each and then one share for $40. This person has one
share for which they paid $47.50. So, the value of the rights must be $2.50 since this
works out evenly under both scenarios.
Explanation for Choice B:
This is the difference between the market price of the stock and the subscription price.
This is not the correct theoretical market value of one right prior to the ex-rights date,
using the formula given. Please see the correct answer for a complete explanation.
Explanation for Choice C:
This is the subscription price of the stock. This is not the correct theoretical market
value of one right prior to the ex-rights date, using the formula given. Please see the
correct answer for a complete explanation.
Explanation for Choice D:
This is not the correct theoretical market value of one right prior to the ex-rights date,
using the formula given. Please see the correct answer for a complete explanation.
69. Question ID: ICMA 10.P2.072 (Topic: L-T Financial Management-Financial
Instruments )
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:
Common stock, 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
If public companies in Clark’s industry are trading at twelve times earnings, what is the
estimated value per share of Clark?

 A. $24.00.
 B. $9.00.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 C. $12.00.
 D. $15.00.correct
Question was not answered
Correct Answer Explanation:
The question tells us that public companies in Clark's industry are trading at twelve
times earnings. So first we need to calculate Clark's earnings per share, then multiply
that by the earnings multiple of 12 to calculate the estimated value per share of Clark.
To calculate EPS, we need to divide net income by the number of shares outstanding.
The amount of the dividend is irrelevant, because it is a dividend on common stock.
(Since this company does not have any preferred stock, the dividend must be on
common stock.) Only dividends on preferred stock are subtracted from net income in
calculating income available to common shareholders. The dividends paid to common
stockholders are part of the income available to common stockholders, so they are not
subtracted from net income.
Par value is $1 per share, and common stock is $3,000,000. Therefore, there are
3,000,000 shares outstanding ($3,000,000 ÷ $1).
Net income of $3,750,000 divided by 3,000,000 shares outstanding equals EPS of
$1.25 per share. Multiplying $1.25 per share by 12 gives us an estimated value per
share of $15.00.
Explanation for Choice A:
This is retained earnings divided by the number of shares outstanding and then
multiplied by 12. "Earnings" means earnings per share. Earnings per share should be
calculated, then multiplied by the earnings multiple of 12 to calculate the estimated
value per share. Earnings per share is income available to common stockholders
divided by the number of common shares outstanding. "Retained earnings" is the
balance sheet account that accumulates net income in a permanent account. Retained
earnings is not used in calculating earnings per share.
Explanation for Choice B:
The question tells us that public companies in Clark's industry are trading at twelve
times earnings. So first we need to calculate Clark's earnings per share, then multiply
that by the earnings multiple of 12 to calculate the estimated value per share of Clark.
To calculate EPS, we need to divide net income by the number of shares outstanding.
This answer results from calculating EPS by subtracting dividends from net income and
then dividing by the number of shares outstanding. The only dividends that should be
subtracted from net income in calculating EPS are preferred dividends, and this
company does not have any preferred stock. Common dividends belong to the common
stockholders and they are included in earnings per share.
Explanation for Choice C:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This is the par value of $1 per share multiplied by the earnings multiple of 12.
"Earnings" refers to earnings per share. Earnings per share should be calculated, then
multiplied by the earnings multiple of 12 to calculate the estimated value per share.
Earnings per share is income available to common stockholders divided by the number
of common shares outstanding.
70. Question ID: CMA 695 P1 Q13 (Topic: L-T Financial Management-Financial
Instruments )
The equity section of Smith Corporation's statement of financial position is presented
below.

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

Common stock, $5 par 10,000,000
Paid-in capital in excess of par 18,000,000
Retained earnings 9,000,000
Net worth $49,000,000
The common shareholders of Smith Corporation have preemptive rights. If Smith
Corporation issues 400,000 additional shares of common stock at $6 per share, a
current holder of 20,000 shares of Smith Corporation's common stock must be given the
option to buy

 A. 3,774 additional shares.

 B. 4,000 additional shares.correct
 C. 1,000 additional shares.
 D. 3,333 additional shares.
Question was not answered
Correct Answer Explanation:
Because the shareholder currently owns 1% of the company's shares ($10,000,000 in
the common stock account divided by $5 par value gives 2,000,000 shares), the
shareholder is entitled to buy 1% of the newly issued shares. Since the company is
issuing 400,000 new shares, 1% of this is 4,000 shares.
Explanation for Choice A:
Because the shareholder currently owns 1% of the company's shares ($10,000,000 in
the common stock account divided by $5 par value gives 2,000,000 shares), the
shareholder is entitled to buy 1% of the newly issued shares.
Explanation for Choice C:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Because the shareholder currently owns 1% of the company's shares ($10,000,000 in
the common stock account divided by $5 par value gives 2,000,000 shares), the
shareholder is entitled to buy 1% of the newly issued shares.
Explanation for Choice D:
Because the shareholder currently owns 1% of the company's shares ($10,000,000 in
the common stock account divided by $5 par value gives 2,000,000 shares), the
shareholder is entitled to buy 1% of the newly issued shares.
71. Question ID: CFM CH19 II.12 (Topic: L-T Financial Management-Financial
Instruments )
The market price of Mulva Corporation's common stock is $60 per share, and each
share gives its owner one subscription right. Four rights are required to purchase an
additional share of common stock at the subscription price of $54 per share.
If Mulva's common stock is currently selling "rights-on," the theoretical value of a right is
closest to

 A. $6.00
 B. $1.20correct
 C. $1.50
 D. $0.96
Question was not answered
Correct Answer Explanation:
The formula for determining the value of one stock right when the price of the stock is
rights-on is

P0 − Pn

Vr =
r+1

Where:

Vr = Value of right
P0 = Value of one share with rights attached
Pn = Subscription (sale) price of one newly issued share
r = Number of rights required to buy one share
 Hock P2 2020
Section B - Corporate Finance.
Answers
Putting the information from the question into the formula, we get [(60 - 54) / (4 + 1)].
Solving the formula, we get $1.20 as the value of the right when the share is selling
rights-on.
Explanation for Choice A:
This is the difference between the subscription price and the price of the share when it
is selling with the rights (rights-on).
Explanation for Choice C:
The formula for determining the value of one stock right when the price of the stock is
rights-on is

P0 − Pn

Vr =
r+1

Where:

Vr = Value of right
P0 = Value of one share with rights attached
Pn = Subscription (sale) price of one newly issued share
r = Number of rights required to buy one share
This answer is

P0 − Pn

Vr =
r

The denominator of the formula needs to be r + 1 instead of r.

Explanation for Choice D:
This is not the correct answer. See the correct answer for a complete explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
 Hock P2 2020
Section B - Corporate Finance.
Answers
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
72. Question ID: CIA 593 IV.56 (Topic: L-T Financial Management-Financial
Instruments )
Which of the following scenarios would encourage a company to use short-term loans to
retire its 10-year bonds that have 5 years until maturity, assuming the bonds have a call
provision?

 A. The company is experiencing cash flow problems.

 B. The company expects interest rates to increase over the next 5 years.
 C. Interest rates have increased over the last 5 years.
 D. Interest rates have declined over the last 5 years.correct
Question was not answered
Correct Answer Explanation:
If interest rates have declined since the bonds were issued, the company can take out
new financing at a lower rate of interest and use the money from the new financing to
retire the original, more expensive debt. This will lower their cost of interest for the next
five years.
Explanation for Choice A:
If the company switches to short-term loans, they will essentially have to retire the
bonds early as the loans become due. If they are having cash flow problems, this will
make those problems worse by increasing the short-term cash outflows that will be
required.
Explanation for Choice B:
If short-term rates will rise in the future, the company will not benefit by switching to
short-term loans, for which the rate will go up in future periods.
Explanation for Choice C:
If interest rates have increases in the past five years the company is better off keeping
the bonds that they have issued because the interest rate on the bonds is lower than
what the interest rate on the new loans would be.
73. Question ID: CMA 689 1.1 (Topic: L-T Financial Management-Financial
Instruments )
Gleason Industries is about to issue $3 million of bonds with a coupon rate of 8%. As
inflation is causing interest rates to rise above 8%:

 A. The value of the bonds will be greater than their face value.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 B. The bonds will sell at a discount as the required rate of return devalues the
bonds.correct
 C. The face value of the bonds will decline.
 D. The bonds will sell at a premium to compensate investors for the low stated rate.
Question was not answered
Correct Answer Explanation:
Because the bonds will have an interest rate that is lower than the market rate, the bond
will need to sell at a discount so that the effective interest rate is equal to the higher
market interest rate.
Explanation for Choice A:
Because the bonds will have an interest rate that is lower than the market rate, the bond
will need to sell at a discount so that the effective interest rate is equal to the higher
market interest rate. The sales price is the value of the bond and the sales price will be
less than the face amount of the bond.
Explanation for Choice C:
The face value of the bonds will not change, no matter what the market rate of interest
is or no matter what inflation is. The face value is set and determined and does not
change.
Explanation for Choice D:
Because the bonds will have an interest rate that is lower than the market rate, the bond
will need to sell at a discount so that the effective interest rate is equal to the higher
market interest rate. When they sell at a premium, the selling price is higher than the
face amount.
74. Question ID: CMA 692 1.12 (Topic: L-T Financial Management-Financial
Instruments )
If Brewer Corporation's bonds are currently yielding 8% in the marketplace, why is the
firm's cost of debt lower?

 A. Market interest rates have increased.

 B. Interest is deductible for tax purposes.correct
 C. Additional debt can be issued more cheaply than the original debt.
 D. There should be no difference; cost of debt is the same as the bonds' market yield.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
A firm's cost of debt is equal to the market yield rate reduced for the tax deductibility of
interest. The tax deductibility of interest always causes the market yield rate to be
higher than the firm's cost of debt capital.
The cost of debt capital is the net effect of the market yield rate and the offsetting tax
deduction. The actual cost of debt equals the market yield rate times (1 − the marginal
tax rate). Thus, if a firm with an 8% market yield rate is in a 40% tax bracket, the net
cost of the debt capital is 4.8% [8% x (1 − 0.4)].
Explanation for Choice A:
A firm's cost of debt is equal to the market yield rate reduced for the tax deductibility of
interest. The tax deductibility of interest always causes the market yield rate to be
higher than the firm's cost of debt capital.
Explanation for Choice C:
Additional debt may or may not be issued more cheaply than earlier debt, depending
upon the interest rates in the market place.
Explanation for Choice D:
A firm's cost of debt is equal to the market yield rate reduced for the tax deductibility of
interest. The tax deductibility of interest always causes the market yield rate to be
higher than the firm's cost of debt capital.
75. Question ID: ICMA 13.P2.024 (Topic: L-T Financial Management-Financial
Instruments )
Vega Inc. needs to raise $50,000,000 for expansion. The two available options are to
sell 7%, 10-year bonds at face value or to sell 5% preferred stock at par for which
annual dividends would be paid. Vega’s effective income tax rate is 30%. Which one of
the following best describes the difference in Vega’s cash flow for the second year after
issue?

 A. Cash flow with the stock issue is $525,000 higher.

 B. Cash flow with the bond issue is $50,000 higher.correct
 C. Cash flow with the bond issue is $225,000 higher.
 D. Cash flow with the stock issue is $700,000 higher.
Question was not answered
Correct Answer Explanation:
The after-tax interest rate on the bonds will be 70% of 7% (0.70 × [1 − 0.30]), or 4.9%.
The after-tax cash outflow for interest in the second year after issue will be $50,000,000
× 0.049, or $2,450,000.
The cash outflow for dividends on the preferred stock in the second year after issue will
be $50,000,000 × 0.05, or $2,500,000.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Thus the net cash flow for the second year after issue with the bond issue will be
$50,000 higher. In other words, the net cash benefit of selling the bonds instead of the
preferred stock will be $50,000. Because the cost of capital for the bonds will be 4.9%
versus 5% for the preferred stock, the cost of the bonds will be $50,000 lower than the
cost of the preferred stock, so the cash flow with the bond issue will be $50,000 higher.
Explanation for Choice A:
This answer results from using a 35% effective tax rate to adjust the bond interest and
using a 30% tax rate to adjust the preferred stock dividend. The effective tax rate for the
bond interest is 30%, and the preferred dividend should not be adjusted at all because
dividends are not tax deductible.
Explanation for Choice C:
This answer results from using a 35% effective tax rate. The effective tax rate is 30%.
Explanation for Choice D:
This answer results from calculating the cost of the preferred stock as if the preferred
dividend were tax-deductible. Dividends paid are not tax-deductible, so the dividend rate
should not be adjusted for taxes.
76. Question ID: ICMA 08.P3.029 (Topic: L-T Financial Management-Financial
Instruments )
Frasier Products has been growing at a rate of 10% per year and expects this growth to
continue and produce earnings per share of $4.00 next year. The firm has a dividend
payout ratio of 35% and a beta value of 1.25. If the risk-free rate is 7% and the return on
the market is 15%, what is the expected current market value of Frasier's common
stock?

 A. $14.00.
 B. $28.00.
 C. $20.00.correct
 D. $16.00.
Question was not answered
Correct Answer Explanation:
This requires the use of both the Capital Asset Pricing Model and the Dividend Growth
Model. First, we use the CAPM to find the investors' required rate of return:
r = rF + β(rM − rF)
Where:
rF = the risk-free rate
rM = the market rate of return
β = the stock's beta coefficient
 Hock P2 2020
Section B - Corporate Finance.
Answers
Plugging the numbers into the formula, we have:
r = 0.07 + 1.25(0.15 − 0.07) = 0.17
Next, we take the investors' required rate of return and use it as the r in the Dividend
Growth Model, stated to solve for P0, to find the expected current market value of a
share of stock:

d1

P0 =

r−g

Where:
P0 = the fair value today of a share of stock
d1 = the next annual dividend to be paid
r = the investors' required rate of return
g = the expected growth rate of the dividend
Earnings per share next year are expected to be $4, and the dividend payout ratio is
0.35. Therefore, the next dividend will be $4 × 0.35, or $1.40.
Plugging these numbers into the Dividend Growth Model, we get
P0 = $1.40 / (0.17 − 0.10) = $20
Explanation for Choice A:
This answer results from using just the growth rate in the denominator of the Dividend
Growth Model. However, the denominator of the Dividend Growth Model is r − g, where
r = the investors' required rate of return and g = the growth rate.
Explanation for Choice B:
This answer results from using the return on the market minus the growth rate in the
denominator of the Dividend Growth Model. However, the denominator of the Dividend
Growth Model is r − g, where r = the investors' required rate of return and g = the growth
rate.
Explanation for Choice D:
This answer could result from using 10% minus the beta coefficient in the denominator
of the Dividend Growth Model. However, the denominator of the Dividend Growth Model
is r − g, where r = the investors' required rate of return and g = the growth rate.
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77. Question ID: CMA 689 1.4 (Topic: L-T Financial Management-Financial
Instruments )
Wilton Corporation has 5,000 shares of 6% cumulative, $100 par value, preferred stock
outstanding and 175,000 shares of common stock outstanding. No dividends have been
paid by the company since May 31, year 2. For the year ended May 31, year 4, Wilton
had net income of $1,450,000 and wishes to pay common shareholders a dividend
equivalent to 25% of net income. The total amount of dividends to be paid by Wilton
Corporation at May 31, year 4 is:

 A. $407,500.
 B. $362,500.
 C. $422,500.correct
 D. $392,500.
Question was not answered
Correct Answer Explanation:
Total dividends include the dividends on both common shares and preferred shares.
The common stock dividends were $1,450,000 × 25% = $362,500. As the cumulative
preferred dividends must be paid before the common dividends are paid, they are also
included into computation. Since the cumulative preferred dividends were not paid or
declared in the previous period, two years worth of cumulative preferred dividends must
be paid in the current period before any common dividends can be paid. The amount
due for the cumulative preferred dividend is: 5,000 shares × $100 par value × 6% × 2
years = $60,000. So, the total dividends to be paid are $362,500 + $60,000 = $422,500.
Explanation for Choice A:
This answer results from subtracting the preferred dividend to be paid ($60,000) from
net income before calculating the amount of the common dividend to be paid. The
problem says that the company wishes to pay common shareholders a dividend
equivalent to 25% of net income, not 25% of net income reduced by the dividend to be
paid to preferred shareholders.
Note that net income minus the cumulative preferred dividend paid is not income
available to common shareholders. When there is cumulative preferred stock, income
available to common shareholders is calculated by subtracting from net income the
cumulative preferred dividends earned, whether or not those dividends were paid.
Furthermore, even if net income minus the cumulative preferred dividends
paid were the correct way to calculate income available to common shareholders,
income available to common shareholders is used only for calculating earnings per
share, not for calculating the amount to pay to common shareholders as a dividend.
Explanation for Choice B:
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Section B - Corporate Finance.
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This is the amount of the common stock dividend and excludes the preferred stock
dividend. See the correct answer for a complete explanation.
Explanation for Choice D:
This answer includes only 1 year of the cumulative preferred dividend. Because the
cumulative preferred dividend was not declared in the previous year, the calculation
needs to include 2 years of cumulative preferred dividends.
78. Question ID: CIA 1192 IV.47 (Topic: L-T Financial Management-Financial
Instruments )
A downward-sloping yield curve depicting the term structure of interest rates implies
that:

 A. Prevailing short-term interest rates are higher than prevailing long-term interest
rates.correct
 B. Interest rates have declined over recent years.
 C. Prevailing short-term interest rates are lower than prevailing long-term interest rates.
 D. Interest rates have increased over recent years.
Question was not answered
Correct Answer Explanation:
If the yield curve slopes downward, that indicates that the expected long-term interest
rates are lower than the current interest rates.
Explanation for Choice B:
Past interest rates are not included in the yield curve. See the correct answer for a
complete explanation.
Explanation for Choice C:
If the yield curve slopes downward, that indicates that the expected long-term interest
rates are lower, not higher, than the current interest rates.
Explanation for Choice D:
Past interest rates are not included in the yield curve. See the correct answer for a
complete explanation.
79. Question ID: ICMA 10.P2.124 (Topic: L-T Financial Management-Financial
Instruments )
Which one of the following best describes the record date as it pertains to common
stock?

 A. The date that is chosen to determine the ownership of shares.correct

 B. The 52-week high for a stock published in the Wall Street Journal.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 C. Four business days prior to the payment of a dividend.
 D. The date on which a prospectus is declared effective by the Securities and Exchange
Commission.
Question was not answered
Correct Answer Explanation:
The record date is the eligibility date for common shareholders to receive a declared
dividend. A shareholder who owns this stock on the record date will receive the dividend
on those shares.
Explanation for Choice B:
The record date refers to the issuance of dividends and those shareholders who will
receive a dividend, not the stock price itself.
Explanation for Choice C:
There is no firm rule as to the number of days between the record date and the payment
date.
Explanation for Choice D:
The record date refers to the issuance of dividends and who is entitled to them. It does
not relate to the prospectus.
80. Question ID: CIA 593 IV.49 (Topic: L-T Financial Management-Financial
Instruments )
Assume that nominal interest rates just increased substantially but that the expected
future dividends for a company over the long run were not affected. As a result of the
increase in nominal interest rates, the company's stock price should

 A. Decrease.correct
 B. Stay constant.
 C. Increase.
 D. Change, but in no obvious direction.
Question was not answered
Correct Answer Explanation:
The question does not say whether the dividend is expected to increase or not, but that
information does not affect the correct answer. Either the Dividend Growth Model or the
Zero Growth Dividend Model can be used to determine the answer to this question.
If the dividend is assumed to be growing and the Dividend Growth Model is used, the
formula is:
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Section B - Corporate Finance.
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P0 = Next Annual Dividend / (Investors' Required Rate of Return − Annual Future
Growth Rate of the Dividend)
If the dividend is not assumed to be growing and the Zero Growth Dividend Model is
used, the formula is:
P0 = Annual Dividend / Investors' Required Rate of Return
An increase in the nominal interest rate will cause the Investors' Required Rate of
Return as used in both formulas to increase. As a result, the denominator of either
formula will increase while the numerator stays the same, and the result will be a
decreased market price for the stock.
Explanation for Choice B:
A higher interest rate increases the required return of investors, which results in a lower
stock price.
Explanation for Choice C:
A higher interest rate increases the required return of investors, which results in a lower
stock price.
Explanation for Choice D:
A higher interest rate increases the required return of investors, which results in a lower
stock price.
81. Question ID: CMA 1288 1.9 (Topic: L-T Financial Management-Financial
Instruments )
A financial manager usually prefers to issue preferred stock rather than debt because

 A. The cost of fixed debt is less expensive since it is tax deductible even if a sinking fund
is required to retire the debt.
 B. Payments to preferred stockholders are not considered fixed payments.
 C. In a legal sense, preferred stock is equity; therefore, dividend payments are not legal
obligations.correct
 D. The preferred dividend is often cumulative, whereas interest payments are not.
Question was not answered
Correct Answer Explanation:
Though preferred stock shares some of the characteristics of bonds, the payment of
dividends is not a legal requirement for preferred shares. Therefore, if the company
does not pay a preferred dividend in one period, it is not in default on the shares.
However, if interest on debt is not paid one period, the company is technically in default
on the bonds and can be forced into bankruptcy and liquidation. Non-payment of a
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Section B - Corporate Finance.
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dividend cannot force a company into bankruptcy and liquidation, an advantage for
preferred shares in contrast to debt.
Explanation for Choice A:
This is a reason to issue debt instead of preferred shares. The question asks for a
reason to issue preferred shares instead of debt.
Explanation for Choice B:
Even though a preferred dividend is not a legal requirement, it is considered to be a
fixed payment. Preferred dividends are set as a percentage of the preferred stock's par
value when the preferred stock is issued. That percentage does not change and the par
value upon which it is based does not change, so the preferred dividend is a fixed
payment. The only choice the company's directors have is whether or not to declare the
dividend each period. Furthermore, if the preferred stock is cumulative, even if the
dividend is not paid in a given period, that period's dividend will need to be paid in the
future before any future common dividends can be paid.
Explanation for Choice D:
This is a correct statement in that preferred dividends are often cumulative and interest
is not. However, interest is not cumulative because it must be paid every period, no
matter what. So, preferred shares are preferable because even if the preferred stock's
dividend is cumulative, it does not need to be paid each period.
82. Question ID: CMA 695 1.6 (Topic: L-T Financial Management-Financial
Instruments )
If a $1,000 bond sells for $1,125, which of the following statements are correct?
I. The market rate of interest is greater than the coupon rate on the bond.
II. The coupon rate on the bond is greater than the market rate of interest.
III. The coupon rate and the market rate are equal.
IV. The bond sells at a premium.
V. The bond sells at a discount.

 A. II and IV.correct
 B. I and V.
 C. I and IV.
 D. II and V.
Question was not answered
Correct Answer Explanation:
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The bond is selling at a premium because its price is higher than its face value. Since
the bond is selling at a premium, the market rate of interest is lower than the stated rate
(coupon rate) on the bond.
Explanation for Choice B:
This bond sells at a premium, not a discount. When a bond sells at a premium (a price
higher than the face value) the market rate of interest is lower than the stated rate of
interest.
Explanation for Choice C:
When a bond sells at a premium (a price higher than the face value) the market rate of
interest is lower than the stated rate of interest.
Explanation for Choice D:
When the market price is higher than the face value, the bond sells at a premium, not a
discount.
83. Question ID: CMA 688 1.9 (Topic: L-T Financial Management-Financial
Instruments )
Each share of non-participating, 8%, cumulative preferred stock in a company that
meets its dividend obligations has all of the following characteristics except

 A. Voting rights in corporate elections.correct

 B. A superior claim to common stock equity in the case of liquidation.
 C. Dividend payments that are not tax deductible by the company.
 D. No principal repayments.
Question was not answered
Correct Answer Explanation:
Preferred shares do not have the right to vote in corporate elections. Since the question
asks for which of the items is not a characteristic of this type of share, this is the correct
answer.
Explanation for Choice B:
In the case of a liquidation preferred shares have a superior claim to the assets of the
company compared to common shareholders. Since the question asks for which is not a
characteristic, this answer is incorrect because this is a characteristic of preferred
shares.
Explanation for Choice C:
The dividends that are paid to preferred shareholders are not tax deductible. Since the
question asks for which is not a characteristic, this answer is incorrect because this is a
characteristic of preferred shares.
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Section B - Corporate Finance.
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Explanation for Choice D:
Preferred shares (and common shares) do not have a principal repayment. Since the
question asks for which is not a characteristic, this answer is incorrect because this is a
characteristic of preferred shares.
84. Question ID: HOCK CMA P2 SDV4 (Topic: L-T Financial Management-Financial
Instruments )
New Company's sales and profits are growing rapidly, and so is its dividend. Its dividend
is growing at an annual rate of 25%. This growth in the dividend is expected to continue
for two years. After that, the rate of growth is expected to slow down to 10% per year.
The investors' required rate of return on the stock is 16%. The next annual dividend is
expected to be $1.00. The beta of New Company's stock is 1.5. The U.S. Treasury bill
rate is 4%.
What is an appropriate market price for New Company's stock?

 A. $4.00
 B. $13.80
 C. $18.88correct
 D. $23.00
Question was not answered
Correct Answer Explanation:
Finding the market price of this stock requires the use of the 2-stage dividend discount
model, since the annual rate of growth in the dividend is expected to be 25% for two
years and then decrease to 10%.
The first step is to find the present values of the dividends to be received during the first
two years and sum the results. The Year 2 dividend is 125% of the Year 1 dividend.

Present Value
End of Year Dividend PV Factor @ 16% of Dividend
1 $1.00 0.862 $ 0.862
2 1.25 0.742 0.929
PV of future dividends - Years 1 and 2: $1.791
We next project the dividend for Year 3 by multiplying the Year 2 dividend ($1.25) by 1 +
the growth rate for Year 3 (1.10). The Year 3 dividend is therefore projected to be $1.25
× 1.10, or $1.38.
Now, we use the Constant Growth Model (Dividend Growth Model), and we pretend that
Year 3 is Year 1, and so the end of Year 2 becomes Year 0. We use this model to
calculate what the value of the stock will be at the end of Year 2, assuming a required
 Hock P2 2020
Section B - Corporate Finance.
Answers
rate of return of 16% and an annual growth in dividends of 10% going forward from the
end of Year 2, beginning with Year 3:
P2 = d3 / (r − g)
P2 = $1.38 / (0.16 − 0.10)
P2 = $23.00
This present value of $23.00 occurs at the end of Year 2, not at Year 0. Therefore, it
needs to be discounted back 2 years to Year 0. We will discount it back as though it is a
single sum that will be received in 2 years. The present value of $1 factor for 2 years at
16% is 0.743, so the present value of $23.00 two years from now is $23.00 × 0.743, or
$17.09. This is the present value as of Year 0 of the dividends to be received beginning
at the end of Year 3 and continuing indefinitely.
The final step is to add together the present value of the future dividends for Years 1
and 2 ($1.79) and the present value of the dividends to be received from Year 3 to
infinity ($17.09) to calculate the value today, at Year 0, for a share of this stock:
$1.79 + $17.09 = $18.88
$18.88 is an appropriate market price for this stock, given the projected dividends and
the 16% required rate of return by investors in the stock.
Explanation for Choice A:
$4.00 is the current annual dividend divided by the current rate of growth.
Explanation for Choice B:
$13.80 is the projected Year 3 dividend divided by the Year 3 growth rate.
Explanation for Choice D:
This is the Year 3 dividend divided by the difference between the investors' required
rate of return and the growth rate, as in the Dividend Growth Model. This is only one
part of the calculation needed to determine the appropriate market price for the stock.
85. Question ID: CMA 696 1.1 (Topic: L-T Financial Management-Financial
Instruments )
A company's stock trades rights-on for $50.00 and ex-rights for $48.00. The
subscription price for rights holders is $40.00, and four rights are required to purchased
one share of stock.
The value of a right while the stock is still trading rights-on is

 A. $2.00correct
 B. $1.60
 C. $0.40
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Section B - Corporate Finance.
Answers
 D. $0.50
Question was not answered
Correct Answer Explanation:
In order to solve this question, we need to determine the value of the right when it is
selling rights-on. This is done using the following formula: Vr=Po - Pn / (r + 1) Solving for
this equation, we get ($50 - $40) / (4 + 1) = $2.00.
Explanation for Choice B:
This is the rights on value of the right if the subscription price is $40 and the value of the
share with the right is $48. See the correct answer for a complete explanation.
Explanation for Choice C:
This is the rights on value of the right if the subscription price is $48. See the correct
answer for a complete explanation.
Explanation for Choice D:
This is the ex-rights value of the right if the subscription price is $48. See the correct
answer for a complete explanation.
86. Question ID: HOCK CFMQ8 (Topic: L-T Financial Management-Financial
Instruments )
Preferred stock with a par value of $100 pays an annual dividend of 5%. If investors
require a 3.75% rate of return, what is the price of the preferred stock?

 A. $103.75
 B. $100.00
 C. $98.75
 D. $133.33correct
Question was not answered
Correct Answer Explanation:
If the preferred stock pays a 5% annual dividend on the par value of $100, the annual
dividend will be $100 × 0.05, or $5. If investors require a 3.75% rate of return, we use
the perpetual annuity model and divide the annual dividend of $5 by the required rate of
return to calculate the market value of the stock. $5 ÷ 0.0375 = $133.33.
Explanation for Choice A:
This is the par value of the stock plus the investors' required rate of return.
Explanation for Choice B:
This is the par value of the stock.
 Hock P2 2020
Section B - Corporate Finance.
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Explanation for Choice C:
If the investors' required rate of return is lower than the rate of return based on the par
value, the price of the preferred stock will be above its par value, not below.
87. Question ID: ICMA 10.P2.116 (Topic: L-T Financial Management-Financial
Instruments )
The call provision in some bond indentures allows

 A. the bondholder to exchange the bond, at no additional cost, for common shares.
 B. the issuer to exercise an option to redeem the bonds.correct
 C. the issuer to pay a premium in order to prevent bondholders from redeeming bonds.
 D. the bondholder to redeem the bond early by paying a call premium.
Question was not answered
Correct Answer Explanation:
A corporate bond indenture may include a call provision. A call provision allows the
bond issuer to buy back the bond at a stated price before its maturity date. The call
price is usually above the par (face) value of the bond. A call provision gives the
company flexibility, because if interest rates decline, the company can call the higher-
interest bonds and refinance that issue at a lower interest rate. Or, if the company feels
that the covenants in the bond indenture are too restrictive and the bond is callable, the
company may choose to refinance the bond if it is able to issue another bond to pay off
the callable bond that does not have such restrictive covenants.
Explanation for Choice A:
A convertible provision, not a call provision, allows bonds to be converted into common
shares.
Explanation for Choice C:
Bondholders do not redeem bonds. To "redeem" means to recover ownership of by
paying a specified sum. Only the issuer of a bond can redeem the bond, because
redeeming a bond takes place when the issuer buys the bond issue back from the
holders.
Explanation for Choice D:
The bondholder does not redeem the bond. To "redeem" means to recover ownership
of by paying a specified sum. Only the issuer of a bond can redeem the bond, because
redeeming a bond takes place when the issuer buys the bond issue back from the
holders.
88. Question ID: CMA 1288 1.8 (Topic: L-T Financial Management-Financial
Instruments )
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Section B - Corporate Finance.
Answers
A stockholder owns 10 shares of Shudo Corporation common stock at a current market
price of $10 per share. The corporation will allow each shareholder to buy proportional
new shares of stock at $9 per share. Currently, there are 5,000 shares outstanding and
500 new shares will be issued. What is the value of one right (rounded to the nearest
cent)?

 A. $.91.
 B. $.09.correct
 C. $10.00.
 D. $9.09.
Question was not answered
Correct Answer Explanation:
In order to solve this question, we need to determine the value of the right when it is
selling rights-on. This is done using the following formula:

Po − Pn

Vr =
r+1

Where:
Po = The value of a share with the rights still attached
Pn = The subscription (sales) price of a share
r = The number of rights needed to buy a new share
Vr = The value of the right
Since 5,000 shares are outstanding and 500 new shares will be issued, 10 shares will
be required to buy a new share (5,000 ÷ 500).
Putting the values into the formula, we calculate that the value of one right is

10 − 9
Vr = = 0.0909
10 + 1
Explanation for Choice A:
This is the value of the 10 rights that will be required to purchase a new share of stock.
Explanation for Choice C:
This is simply the current market price of the share of stock.
Explanation for Choice D:
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Section B - Corporate Finance.
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This answer results from incorrectly interpreting the calculated answer. See the correct
answer for a complete explanation.
89. Question ID: ICMA 10.P2.111 (Topic: L-T Financial Management-Financial
Instruments )
Which one of the following provides the best measure of interest rate risk for a
corporate bond?

 A. Maturity.
 B. Yield to maturity.
 C. Bond rating.
 D. Duration.correct
Question was not answered
Correct Answer Explanation:
Interest rate risk is the risk that the value of the investment will change over time as a
result of changes in the market rate of interest. The duration of a fixed income security
measures how vulnerable the market value of the security is to future changes in market
interest rates. When market interest rates increase, market values of fixed income
securities decrease. And when market interest rates decrease, market values of fixed
income securities increase.
But not all fixed income securities vary in value by the same extent. How much an
individual fixed income security will vary in value with changes in interest rates depends
upon its duration. As the duration increases, the volatility of the price of the debt
instrument increases. The longer the time to wait until a future payment is received, the
greater will be the effect of a change in the rate of interest on the present value of the
payment.
So the market value of short-term securities such as money market financial
instruments will be only slightly affected, if at all, by changes in the market interest rate.
But the market value of a long-term corporate bond with several years to maturity will be
significantly affected by market interest rate changes.
Explanation for Choice A:
The maturity date of a fixed income security is the date it matures and the date the
issuer of the security must repay the full amount of the principal plus any accrued and
unpaid interest to the investors. The length of time to the security's maturity date is a
factor in measuring the amount of interest rate risk for a corporate bond, but it is not the
only factor. The lengths of time to the scheduled payments of interest prior to its
maturity are also important.
Explanation for Choice B:
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The yield to maturity of a bond is its effective annual yield, including the amortization of
any premium or discount, if the bond is held until it matures. It does not provide any
measure of interest rate risk for a corporate bond.
Explanation for Choice C:
Interest rate risk is the risk that the value of the investment will change over time as a
result of changes in the market rate of interest. A bond's rating assigned by the rating
agencies does not provide a measure of its interest rate risk. A bond's rating provides a
means to judge the security's credit, or default, risk.
90. Question ID: CMA 695 1.8.5 Adapted (Topic: L-T Financial Management-
Financial Instruments )
Below is a Statement of Financial Position for Martin Corporation:

Martin Corporation
Statement of Financial Position
(Dollars in millions)
Assets:
Current Assets $ 75
Plant and Equipment 250
Total Assets $325
Liabilities and shareholders' equity:
Liabilities:
Current Liabilities $ 46
Long-term debt (12%) 64
Common equity:
Common stock, $1 par $ 10
Additional paid in capital 100
Retained earnings 105
Total liabilities and shareholders' equity $325
Additional Data:

 The long term debt was originally issued at par ($1,000 per bond) and is currently
trading at $1,250 per bond.
 Martin Corporation can now issue debt at 150 basis points over U.S. treasury
bonds.
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Section B - Corporate Finance.
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 The current risk-free rate (U.S. Treasury bonds) is 7%.
 The expected market return is currently 15%.
 The beta for Martin is 1.25.
 Martin's effective corporate income tax rate is 40%.
 Martin paid a dividend of $1.00 per share last year.
 Martin's dividend is expected to grow at the rate of 5% per year.
What price should Martin's common stock sell for currently?

 A. $8.33
 B. $10.50
 C. $6.67
 D. $8.75correct
Question was not answered
Correct Answer Explanation:
To determine the value of the common stock, it is necessary to use both the Capital
Asset Pricing Model, to find the current cost of Martin's common equity (investors'
required rate of return), and then the Dividend Growth Model, to find the price of the
common stock.
The Capital Asset Pricing Model formula is: R = RF + [β(RM − RF)]. Plugging the values
into the formula, we have 0.07 + [1.25(0.15 − 0.07)] which equals 0.17 or 17%, which is
the investors' required rate of return.
We now have all the information needed to use the Dividend Growth Model to value this
stock. The formula for the Dividend Growth Model is restated to solve for the stock
price, as follows:
P0 = Next Annual Dividend / (Investors' Required Rate of Return − Annual Growth Rate
of Dividends)
P0 = ($1.00 × 1.05) / (0.17 − 0.05)
= $1.05 ÷ 0.12
= $8.75
Explanation for Choice A:
This answer does not take into account the growth rate in the dividend.
Explanation for Choice B:
This is the Next Annual Dividend divided by the Expected Market Return minus the
Annual Growth Rate of Dividends. However, the value of common stock is the Next
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Answers
Annual Dividend divided by the Investors' Required Rate of Return minus the Annual
Growth Rate of Dividends.
Explanation for Choice C:
This is the previous year's dividend divided by the expected market return. However, the
value of common stock is found by means of the Constant Growth Model, which is Next
Annual Dividend divided by the Investors' Required Rate of Return minus the Annual
Growth Rate of Dividends.
91. Question ID: CMA 695 1.2 (Topic: L-T Financial Management-Financial
Instruments )
Which one of the following statements is correct when comparing bond financing
alternatives?

 A. A call provision is generally considered detrimental to the investor.correct

 B. A convertible bond must be converted to common stock prior to its maturity.
 C. A call premium requires the investor to pay an amount greater than par at the time of
purchase.
 D. A bond with a call provision typically has a lower yield to maturity than a similar bond
without a call provision.
Question was not answered
Correct Answer Explanation:
A call provision is usually considered detrimental to the investor because the company
can call the bonds if a cheaper source of financing becomes available. If a cheaper
source is available for the company, it is unlikely that the bondholder will be able to find
an investment opportunity that pays the same rate as the bonds did.
Explanation for Choice B:
Convertible bonds may be converted to shares before their maturity, but it is not
required that they be converted.
Explanation for Choice C:
The call premium is connected to the calling of the bonds by the issuer, not the sale of
the bonds. The call premium is the amount of the premium that the issuer must pay to
call the bonds.
Explanation for Choice D:
Because the call provision is considered to be detrimental to the bondholders, they will
require a slightly higher rate of return on callable bonds, not a lower rate of return.
92. Question ID: CMA 1291 1.6 (Topic: L-T Financial Management-Financial
Instruments )
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Section B - Corporate Finance.
Answers
A major use of warrants in financing is to

 A. lower the cost of debt.correct

 B. avoid dilution of earnings per share.
 C. maintain managerial control.
 D. permit the buy-back of bonds before maturity.
Question was not answered
Correct Answer Explanation:
By including warrants with the bonds that are issued the company is able to reduce the
cost of the debt. This is because the purchaser of the bond is receiving two items of
value - the bond and the warrants. Therefore, the interest rate can be a little bit lower
and the buyer will still purchase the bonds because of the warrant that is attached to it.
Explanation for Choice B:
The issuance of warrants does not affect Basic EPS, but it will cause Diluted EPS to be
reduced.
Explanation for Choice C:
The issuing of warrants has no immediate impact on managerial control of the
company, but if the warrants are exercised, this will decrease managerial control over
the company.
Explanation for Choice D:
The issuance of warrants does not impact whether or not the bonds may be bought-
back before their maturity. This is determined by whether the bonds are callable or not.
93. Question ID: ICMA 13.P2.023 (Topic: L-T Financial Management-Financial
Instruments )
What variable is measured on the horizontal axis of the yield curve?

 A. Yield of the bonds.

 B. Par value of the bonds.
 C. Duration of the bonds.
 D. Years to maturity of the bonds.correct
Question was not answered
Correct Answer Explanation:
The yield curve shows the market rates for various maturities of bonds on a given date.
The years to maturity of the bonds are on the horizontal axis and the market rates are
on the vertical axis.
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Explanation for Choice A:
The yield curve shows the market rates for various maturities of bonds on a given date.
The market rates, or the yields, are on the vertical axis, not the horizontal axis.
Explanation for Choice B:
The par value of an individual bond is its stated amount or its face value. The par value
of bonds is not represented graphically on a yield curve graph.
Explanation for Choice C:
The duration of an individual fixed income security is a weighted average of the times
until the receipt of both interest and principal, weighted according to the proportion of
the total present value of the bond represented by the present value of each cash flow
to be received. Duration is not represented graphically on a yield curve graph.
94. Question ID: CMA 1291 1.7 (Topic: L-T Financial Management-Financial
Instruments )
A call provision

 A. lowers the investors' required rate of return.

 B. protects investors against margin calls.
 C. provides an organization flexibility in financing if interest rates fall.correct
 D. allows bondholders to require the organization to retire the bond before original
maturity.
Question was not answered
Correct Answer Explanation:
A call provision gives the issuer the right to retire (pay off) the bonds before the original
maturity date. This is good for the company because if interest rates fall and there are
cheaper sources of financing available, they can call the older, more expensive bonds
and obtain cheaper sources of financing.
Explanation for Choice A:
If anything, a call provision will cause the investor to require a higher rate of return to
compensate for the risk that the bond will be called before its maturity date.
Explanation for Choice B:
A margin call is related to the purchase of shares on margin, not the call provision of a
bond.
Explanation for Choice D:
A call provision gives the issuer, not the bondholder, the option of retiring the bond
before its maturity date.
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95. Question ID: CMA 693 1.10 (Topic: L-T Financial Management-Financial
Instruments )
The market value of a share of stock is $50, and the market value of one right prior to
the ex-rights date is $2.00 after the offering is announced but while the stock is still
selling rights-on. The offer to the shareholder is that it will take three rights to buy an
additional share of stock at a subscription price of $40 per share. If the theoretical value
of the stock when it goes ex-rights is $47.50, then the shareholder

 A. Receives an additional benefit from a rights offering.

 B. Merely receives a return of capital.
 C. Does not receive any additional benefit from a rights offering.correct
 D. Should redeem the right and purchase the stock before the ex-rights date.
Question was not answered
Correct Answer Explanation:
The question tells us that the market value of one right prior to the ex-rights date is
$2.00. However, the theoretical value of the right (what its market value should be) is
$2.50. We can calculate the theoretical value of the right when the stock is selling
rights-on using this formula:
Vr = (Po − Pn) ÷ ( r + 1)
Where:
Po = the value of a share with the rights still attached
Pn = the subscription price of a share
r = the number of rights needed to buy one new share
Vr = the value of the right
Solving for Vr in this equation, we get
Vr = ($50 − $40) / (3 + 1) = $2.50.
But the market value of the right is only $2.00, according to the question. It is not as
high as it should be. The question tells us that the theoretical value of the share when it
goes ex-rights (the theoretical value of the share without the right) is $47.50. Because
the value of a share when it is ex-rights will be $47.50, if the shareholder were to sell
their rights at the market price of $2.00, they would have only $49.50 worth of value
instead of the $50 they should have. So in this situation, because the market value of
the right is lower than it should be, the rights have no value to the shareholder. The
shareholder does not receive any additional benefit from the rights offering. In fact, the
market value of the shareholder's holdings in the company is decreased.
Explanation for Choice A:
The market value of the right is $2.00 while the stock is still selling rights-on, according
to the question. However, the theoretical value of the right is different from its market
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Section B - Corporate Finance.
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value. Because of that, the shareholder does not receive an additional benefit from the
rights offering. Please see the correct answer for a complete explanation and
calculation of the theoretical value of the right.
Explanation for Choice B:
A shareholder does not receive any return of capital as a result of a right offering.
Please see the correct answer for a complete explanation.
Explanation for Choice D:
This answer is incorrect because the rights cannot be redeemed before the ex-rights
date. The rights cannot be redeemed until they are issued, and the ex-rights date
comes before the issue date.
96. Question ID: CIA 589 IV.56 (Topic: L-T Financial Management-Financial
Instruments )
A call provision in a bond indenture

 A. allows the issuer to call in the bonds before maturity, usually along with payment of an
additional sum called a call premium.correct
 B. requires the issuer to call in its bonds if interest rates rise above a predetermined level
to allow bondholders the opportunity for higher rates.
 C. allows the bondholder the option to buy shares of the company's common stock at a
specified price within a specified period.
 D. permits bondholders to call for additional bond issuances at predetermined intervals.
Question was not answered
Correct Answer Explanation:
A call provisions allows the issuer of the bonds to call the bonds and retire them before
their maturity date. The price at which the bonds are repurchased is usually
predetermined and includes a premium. This premium offsets the loss to the bondholder
when the bonds are called before their maturity.
Explanation for Choice B:
A call provision enables the issuer of the bond to retire the bonds before their maturity
date. It has nothing to do with the interest rate.
Explanation for Choice C:
A call provision does not allow the bondholder the option to buy shares of the
company's common stock at a specified price within a specified period.
Explanation for Choice D:
A call provision does not allow the bondholder to call for additional bond issuances at
predetermined intervals.
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97. Question ID: CIA 1190 IV.53 (Topic: L-T Financial Management-Financial
Instruments )
Which of the following is directly applied in determining the value of a stock when using
the dividend growth model?

 A. The investors' required rate of return on the firm's stock.correct

 B. The firm's cash flows.
 C. The firm's liquidity.
 D. The firm's capital structure.
Question was not answered
Correct Answer Explanation:
The dividend growth model is used to calculate the cost of retained earnings (investors'
required rate of return). The simplified formula is
C = (D1 / P0) + G
where C is the investors' required rate of return, D1 is the next dividend, P0 is the stock's
price, and G is the growth rate in dividends.
The model can be restated and used to determine the stock price when the next year's
dividend, the investors' rate of return (cost of retained earnings) and the growth rate in
dividends are known. The restated formula is
P0 = D1 / (C − G)
Explanation for Choice B:
The firm's cash flow is not used in determining the value of a stock when using the
dividend growth model. The formula for the dividend growth model is:
C = (D1 / P0) + G
When restated to determine the value of a stock, the formula is:
P0 = D1 / (C − G)
Explanation for Choice C:
The firm's liquidity is not used in determining the value of a stock when using the
dividend growth model. The formula for the dividend growth model is:
C = (D1 / P0) + G
When restated to determine the value of a stock, the formula is:
P0 = D1 / (C − G)
Explanation for Choice D:
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The firm's capital structure is not used in determining the value of a stock when using
the dividend growth model. The formula for the dividend growth model is:
C = (D1 / P0) + G
When restated to determine the value of a stock, the formula is:
P0 = D1 / (C − G)
98. Question ID: ICMA 01.P2.127 (Topic: L-T Financial Management-Financial
Instruments )
Which one of the following describes a disadvantage to a firm that issues preferred
stock?

 A. Most preferred stock is owned by corporate investors.

 B. Preferred stock typically has no maturity date.
 C. Preferred stock is usually sold on a higher yield basis than bonds.correct
 D. Preferred stock dividends are legal obligations of the corporation.
Question was not answered
Correct Answer Explanation:
Because equity carries no guarantee of a return, investors typically demand a higher
yield to compensate for the higher risk.
Explanation for Choice A:
Preferred stock can be owned by corporate investors, institutional investors, or private
investors.
Explanation for Choice B:
Preferred stock usually does not have a maturity date, but that is not a disadvantage to
the firm that issues it.
Explanation for Choice D:
The payment of a preferred stock dividends is discretionary. Missing a dividend
payment will not be a default on the part of the issuer. The board of directors can omit
paying a preferred stock dividend if it chooses. Therefore, preferred stock dividends are
not legal obligations of the corporation.
99. Question ID: ICMA 10.P2.122 (Topic: L-T Financial Management-Financial
Instruments )
Which one of the following is a debt instrument that generally has a maturity of ten
years or more?

 A. A chattel mortgage.
 B. A note.
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 C. A bond.correct
 D. A lease.
Question was not answered
Correct Answer Explanation:
Bonds are medium to long-term negotiable debt securities that have been issued by
governments, government agencies, states or other government bodies, international
organizations such as the World Bank, and companies. A bond would generally have a
maturity of ten years or more.
Explanation for Choice A:
Chattel mortgages are loans that are secured by movable, identifiable personal property
such as a car. Since the security for a chattel mortgage is not a long-term fixed asset,
the term of the loan that it secures must be short-term. For example, a car's value
decreases quickly, so it could not be used to secure a ten-year loan.
Explanation for Choice B:
A note may be a short-term loan (under one year) or it may be a term note, for a period
of greater than one year. However, it would seldom have a term as long as 10 years.
Explanation for Choice D:
A lease is normally used to finance the purchase of equipment. Depending on the
equipment, the lease may be anywhere from 1 year to a longer term, but it would
seldom be as long as 10 years.
100. Question ID: ICMA 10.P2.126 (Topic: L-T Financial Management-Financial
Instruments )
All of the following are characteristics of preferred stock except that

 A. its dividends are tax deductible to the issuer.correct

 B. it may be converted into common stock.
 C. it usually has no voting rights.
 D. it may be callable at the option of the corporation.
Question was not answered
Correct Answer Explanation:
Dividends are paid after taxes and are not deductible to the corporation.
Explanation for Choice B:
Preferred stock may have a provision that allows the holders to convert the preferred
stock to common stock at their option. Shareholders may choose to do this in order to
have voting privileges or to take advantage of future increase in the common stock
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price. The terms of a given issue of preferred stock are stated in a document called the
"Certificate of Designation."
Explanation for Choice C:
Preferred stockholders typically do not have voting rights.
Explanation for Choice D:
Preferred stock may have a call provision which allows the corporation to repurchase
the shares at a specific price or at a specified time. The terms of a given issue of
preferred stock are stated in a document called the "Certificate of Designation."
101. Question ID: ICMA 10.P2.120 (Topic: L-T Financial Management-Financial
Instruments )
Which one of the following statements concerning debt instruments is correct?

 A. A 25-year bond with a coupon rate of 9% and one year to maturity has more interest
rate risk than a 10-year bond with a 9% coupon issued by the same firm with one year to
maturity.
 B. A bond with one year to maturity would have more interest rate risk than a bond with 15
years to maturity.
 C. The coupon rate and yield of an outstanding long-term bond will change over time as
economic factors change.
 D. For long-term bonds, price sensitivity to a given change in interest rates is greater the
longer the maturity of the bond.correct
Question was not answered
Correct Answer Explanation:
Duration measures how vulnerable the market value of a fixed-income security is to
future changes in market interest rates. When market interest rates increase, market
values of fixed income securities decrease. And when market interest rates decrease,
market values of fixed income securities increase. But not all fixed income securities
vary in value by the same extent. How much an individual fixed income security will vary
in value with changes in interest rates depends upon its duration.
As a bond’s maturity date approaches, its duration shortens, and its market value
becomes less sensitive to market interest rate changes. So a long-term bond's price
sensitivity to a given change in interest rates will be greater the longer the maturity of
the bond, and the bond will have more interest rate risk. A bond with a shorter maturity
will be less sensitive to market rate changes and thus will have less interest rate risk.
Explanation for Choice A:
Both bonds have the same amount of interest rate risk, because both bonds have the
same coupon rate and both have one year to maturity.
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Explanation for Choice B:
A long-term bond's price sensitivity to a given change in interest rates will be greater the
longer the maturity of the bond, and the bond will have more interest rate risk. A bond
with a shorter maturity will be less sensitive to market rate changes and thus will have
less interest rate risk. A bond with 15 years to maturity would have more interest rate
risk than a bond with one year to maturity.
Explanation for Choice C:
The coupon rate and the yield-to-maturity of a bond do not change over time for the
buyer of that bond. The coupon rate never changes regardless of who holds the bond.
The bond's yield-to-maturity does not change as long as the buyer holds the bond to
maturity. If the investor sells the bond before its maturity date, though, that investor's
yield on the bond will be affected by the market price of the bond received on the date
of the sale.
102. Question ID: ICMA 13.P2.068 (Topic: L-T Financial Management-Financial
Instruments )
An analyst is in the process of determining what the current share price should be for
PaperToy Inc. In early January, the analyst collected the following information on
PaperToy Inc.

 Dividend at end of current year = $1.00

 Yearly dividend increase = 5%
 Expected investor return = 10%
Based on the data provided, the current share price for PaperToy Inc. should be

 A. $21.00.
 B. $20.00.correct
 C. $6.67.
 D. $7.00.
Question was not answered
Correct Answer Explanation:
The dividend growth model should be used to calculate the fair value of the stock. The
dividend growth model is:

d 1

P0 =
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Section B - Corporate Finance.
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r−g

Where: P0 = the fair value today of a share of stock;

d1 = the next annual dividend to be paid;
r = the investors' required rate of return; and
g = the expected growth rate of the dividend.
The next annual dividend to be paid (d1) is the $1.00 dividend at the end of the current
year. Note that the analysis is taking place in early January, and the $1.00 dividend is to
be paid at the end of the current year. Therefore, $1.00 is the next annual dividend to
be paid. It should not be increased by 5% for the purposes of this calculation.
The investors' required rate of return (r) is 10% or 0.10.
The expected growth rate of the dividend (g) is 5% or 0.05.
Therefore,

$1.00
P0 =
0.10 − 0.05
P0 = $20
Explanation for Choice A:
This answer results from increasing the dividend at the end of the current year by 5%
for use in the dividend growth model. Note that the analysis is taking place in early
January, and the $1.00 dividend is to be paid at the end of the current year. Therefore,
$1.00 is the next annual dividend to be paid. It should not be increased by 5% for the
purposes of this calculation.
Explanation for Choice C:
This is $1.00 divided by 0.15. This is an incorrect use of the dividend growth model. The
denominator used should be the investors' required rate of return (r, or 0.10) minus the
expected growth rate of the dividend (g, or 0.05). This answer uses r + g instead of r − g
in the denominator.
Explanation for Choice D:
This is $1.05 divided by 0.15. This is an incorrect use of the dividend growth model for
two reasons:

(1) The analysis is taking place in early January, and the $1.00 dividend is to be paid at the
end of the current year. Therefore, $1.00 is the next annual dividend to be paid, and
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Answers
that should be the numerator in the model. It should not be increased by 5% for the
purposes of this calculation.
(2) The denominator used should be the investors' required rate of return (r, or
0.10) minus the expected growth rate of the dividend (g, or 0.05). This answer uses r + g
instead of r − g in the denominator.
103. Question ID: CMA 692 1.7 (Topic: L-T Financial Management-Financial
Instruments )
Debentures are

 A. income bonds that require interest payments only when earnings permit.
 B. subordinated debt and rank behind convertible bonds.
 C. bonds secured by the full faith and credit of the issuing firm.correct
 D. a form of lease financing similar to equipment trust certificates.
Question was not answered
Correct Answer Explanation:
Debentures are a type of bond that have no collateral behind them. They are supported
only by the company that has issued these bonds, and their full faith and credit.
Explanation for Choice A:
Debenture bonds are bonds that do not have collateral behind them. The payment of
interest only when earnings permit is a characteristic of an income bond.
Explanation for Choice B:
Debenture bonds are bonds that do not have collateral behind them. Debenture bonds
have the same rank as other bonds.
Explanation for Choice D:
Debentures are bonds that are not supported by any collateral. They are not a form of
lease financing and they are not equipment trust certificates that do have collateral.
104. Question ID: ICMA 1603.P2.022 (Topic: L-T Financial Management-Financial
Instruments )
Which one of the following rights is ordinarily sacrificed by the holders of preferred stock
in exchange for other preferences received over common shareholders?

 A. The right to share in the periodic earnings of the company through the receipt of
dividends.
 B. The right to share in the residual assets of the company upon liquidation.
 C. The right to vote for members of the board of directors and in other matters requiring a
vote.correct
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 D. The right to accrue dividend payments in arrears when payments are not made for a
period of time.
Question was not answered
Correct Answer Explanation:
This is a right that is sacrificed by the holders of preferred stock in exchange for other
preferences received over common shareholders. Holders of preferred stock do not
have any right to vote for members of the board of directors or to vote in other matters
requiring a vote.
Explanation for Choice A:
This is not a right that is sacrificed by the holders of preferred stock in exchange for
other preferences received over common shareholders. Holders of preferred stock have
the right to share in the periodic earnings of the company through the receipt of
dividends.
Explanation for Choice B:
This is not a right that is sacrificed by the holders of preferred stock in exchange for
other preferences received over common shareholders. Holders of preferred stock have
the right to share in the residual assets of the company upon liquidation. Their right
takes priority over the right of the common shareholders.
Explanation for Choice D:
If preferred stock is cumulative, preferred stockholders have the right to accrue dividend
payments in arrears when payments are not made for a period of time. Although not all
preferred stockholders have this right (the preferred stock must
be cumulative preferred stock), this is not a right that is sacrificed by the holders of
preferred stock in exchange for other preferences received over common shareholders.
105. Question ID: HOCK RRI 103 (Topic: L-T Financial Management-Derivatives )
All of the following statements about the intrinsic value of an option are true except

 A. The intrinsic value of an option is equal to its market value.correct

 B. The intrinsic value of an option is only one part of its market value.
 C. The intrinsic value of an option is its value, before transaction costs, to an investor who
would buy the option and exercise it immediately.
 D. The intrinsic value of an option is the amount by which it is "in the money."
Question was not answered
Correct Answer Explanation:
The intrinsic value of an option is not equal to its market value. The market value of an
option consists of both its intrinsic value and its time value. The intrinsic value of an
option is the amount by which the option is "in the money" at any given point in time.
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The longer the time before an option's expiration, the more valuable it is, because there
is more time for a favorable price fluctuation to take place in the underlying stock. That
is the option's time value. The time value is the portion of an option's premium (price)
that is in excess of the option's intrinsic value.
Explanation for Choice B:
This is a true statement.
Explanation for Choice C:
This is a true statement.
Explanation for Choice D:
This is a true statement.
106. Question ID: ICMA 19.P2.084 (Topic: L-T Financial Management-Derivatives )
An example of a hedging approach to financing is

 A. using five-year bonds to finance inventory acquisition.

 B. increasing earnings by purchasing stock puts.
 C. matching assets with liabilities of the same maturity.correct
 D. financing building projects with accounts payable.
Question was not answered
Correct Answer Explanation:
One of the ways of hedging risks of financing is to match assets with liabilities that have
a maturity that matches the expected useful life of the asset.
Explanation for Choice A:
One of the ways of hedging risks of financing is to match assets with liabilities that have
a maturity that matches the expected useful life of the asset. Using five-year bonds to
finance inventory acquisition does not do this.
Explanation for Choice B:
Increasing earning by purchasing stock puts is not a way of hedging financing risks.
Explanation for Choice D:
Financing building projects with accounts payable is not a way to hedge financing risks.
107. Question ID: HOCK RRI 11 (Topic: L-T Financial Management-Derivatives )
All of the following are differences between forward contracts and futures
contracts except

 A. Forward contracts have no standard conditions; futures contracts are standardized.

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 B. Forward contracts are used by a wide variety of firms; futures contracts are limited to
large firms.correct
 C. Forward contracts have credit risk; futures contracts have no credit risk because
futures exchanges guarantee all transactions.
 D. Forward contracts are agreements between two parties negotiated by dealers; futures
contracts are traded on exchanges.
Question was not answered
Correct Answer Explanation:
It is not true that forward contracts are used by a wide variety of firms while futures
contracts are limited to large firms. Just the opposite is true. A forward contract is an
over-the-counter agreement between two parties to buy or sell an asset at a certain time
in the future for a certain price. Forward contracts are negotiated between the two
parties by brokers. Because of the costs involved, their use is limited to large firms.
Explanation for Choice A:
This is a true statement.
Explanation for Choice C:
This is a true statement.
Explanation for Choice D:
This is a true statement.
108. Question ID: HOCK RRI 16 (Topic: L-T Financial Management-Derivatives )
Which of the following is not a way to exit an option position?

 A. The option may be allowed to expire on the expiration date.

 B. The option may be returned to the party it was purchased from.correct
 C. The option may be exercised.
 D. The option may be offset, to reverse the original transaction.
Question was not answered
Correct Answer Explanation:
There are three ways to exit an option position, and returning the option to the party it
was purchased from is not one of them.
The option may be exercised by choosing to purchase the underlying security (if a call),
or choosing to sell the underlying security (if a put). Or the position may be offset. To
offset a position, a person who had bought a call would have to sell a call with the same
strike price and expiration, or a person who sold a call would have to buy a call with the
same strike price and expiration. A put would work the same way. The third way to exit
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an option position is to simply allow the option to expire on its expiration date, at which
time it becomes worthless.
Explanation for Choice A:
Allowing the option to expire on the expiration date is a way of exiting an option
position. If an option is not exercised by its expiration date, it simply becomes worthless.
Explanation for Choice C:
Exercising the option is a way of exiting an option position. The option may be
exercised by choosing to purchase the underlying security (if a call), or choosing to sell
the underlying security (if a put).
Explanation for Choice D:
Offsetting the option is a way of exiting an option position. To offset a position, a person
who had bought a call would have to sell a call with the same strike price and expiration,
or a person who sold a call would have to buy a call with the same strike price and
expiration. A put would work the same way.
109. Question ID: ICMA 10.P2.115 (Topic: L-T Financial Management-Derivatives )
Buying a wheat futures contract to protect against price fluctuation of wheat would be
classified as a

 A. swap.
 B. foreign currency hedge.
 C. fair value hedge.
 D. cash flow hedge.correct
Question was not answered
Correct Answer Explanation:
A cash flow hedge is used to protect against variable cash flows of a forecasted
transaction. Buying a wheat futures contract to protect against future price fluctuation of
wheat is protecting against variable cash flows of a forecasted transaction.
The term "cash flow hedge" is used in accounting for hedging activities, and it is
covered in the HOCK Assumed Knowledge e-book, Volume 2.
Explanation for Choice A:
A swap could be a foreign exchange swap, a foreign currency swap, or an interest rate
swap. None of those would be used to protect against future price fluctuation of wheat.
Explanation for Choice B:
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A foreign currency hedge is used in international trade and investing to manage
currency exchange rate risk. It would not be used to protect against future price
fluctuation of wheat.
Explanation for Choice C:
A fair value hedge is used to protect against changes in the fair value of a recognized
asset or liability or an unrecognized firm commitment. Buying a wheat futures contract
to protect against future price fluctuation of wheat does not protect against changes in
the fair value of a recognized asset or liability or an unrecognized firm commitment.
The term "fair value hedge" is used in accounting for hedging activities, and it is covered
in the HOCK Assumed Knowledge e-book, Volume 2.
110. Question ID: HOCK RRI 100 (Topic: L-T Financial Management-Derivatives )
The long party to a futures contract is

 A. the party who is committing to sell the underlying asset as a protection against a
possible declining price of the actual asset.
 B. the party who has the choice to exercise or not exercise the contract.
 C. the party who has no choice but who must comply with the will of the other party to the
contract.
 D. the party who is committing to buy the underlying asset as a protection against a
possible increasing price of the actual asset.correct
Question was not answered
Correct Answer Explanation:
The party to a futures contract who is committing to buy the underlying asset as a
protection against a possible increasing price of the actual financial instrument or
physical commodity holds the long position.
Explanation for Choice A:
The party to a futures contract who is committing to sell the underlying asset as a
protection against a possible declining price of the actual financial instrument or
physical commodity holds the short position.
Explanation for Choice B:
Neither party to a futures contract has a choice to exercise or not to exercise the
contract. The contract must be fulfilled by the holders on its maturity date by one's
selling and one's buying the underlying asset, or by exiting the futures position in
another manner.
Explanation for Choice C:
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Neither party to a futures contract has a choice to exercise or not to exercise the
contract; and so neither one complies with the will of the other party. The contract must
be fulfilled by the holders on its maturity date by one's selling and one's buying the
underlying asset, or by exiting the futures position in another manner.
111. Question ID: HOCK RRI 22 (Topic: L-T Financial Management-Derivatives )
On July 14, an investor goes short on a put option for 100 shares of OSC, Inc. common
stock with a strike price of $9.00, expiring on August 16, at an option premium of $1.50
per share. The market price of OSC on July 14 is $8.00. On August 16, the market price
of OSC is $6.00. How much has the investor gained or lost on the option transaction?
Disregard any brokerage commissions involved.

 A. Gain of $450.
 B. Gain of $300.
 C. Loss of $150.correct
 D. Gain of $150.
Question was not answered
Correct Answer Explanation:
The short party to an option is the one who sells the option and who must comply if the
buyer of the option chooses to exercise it. Here, the short party sold a put option to sell
the underlying stock at $9. The buyer of the option has the right to sell 100 shares of
OSC stock to the seller of the option at a price of $9.00. On the option’s expiration date,
the market price of OSC is $6.00. The buyer of the option exercises the option and sells
the OSC stock to the seller of the option. The seller of the option must purchase the
stock for $9 when its market value is only $6 because the option was exercised. The
seller of the put option has an unrealized loss on the stock of $300 ($3 per share
multiplied by 100 shares).
However, the seller received a premium of $1.50 per share for selling the option and
that partially offsets the loss. Therefore, the seller’s loss is $3.00 per share − $1.50 per
share, or $1.50 per share. Multiplied by 100 shares, the total loss is $150.00.
Explanation for Choice A:
This is the strike price of $9 minus the market price at expiration of $6 plus the option
premium of $1.50, multiplied by 100 shares.
Explanation for Choice B:
This is the strike price of $9 per share multiplied by 100 shares minus the market price
on the expiration date of the option of $6 per share multiplied by 100 shares.
Explanation for Choice D:
This is the gain that would be earned by the long party to a transaction with the same
characteristics.
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112. Question ID: HOCK RRI 18 (Topic: L-T Financial Management-Derivatives )
On July 14, an investor goes long on a put option for 100 shares of ZXY Corporation
common stock with a strike price of $33.00, expiring on August 16, at an option
premium of $1.25 per share. The market price of ZXY on July 14 is $32.50. On August
16, the market price of ZXY is $30.00. How much has the investor gained or lost on the
option transaction? Disregard any brokerage commissions involved.

 A. Gain of $175.correct
 B. Gain of $300.
 C. Loss of $175.
 D. Gain of $75.
Question was not answered
Correct Answer Explanation:
The long party to an option is the one who purchases the option and who has the right
but not the obligation to exercise it. Here, the long party purchased a put option to sell
the stock at $33.00. On the expiration date, the stock’s market price is $30.00. The long
party has made money because he can buy the stock on the market at its market price
of $30.00 and exercise the put to sell it for $33.00.
However, the option buyer also has the premium he paid of $1.25 per share for the
option to consider. So his gain per share is $33.00 − $30.00 − $1.25 per share = $1.75.
Multiplied by 100 shares, the total gain is $175.
Explanation for Choice B:
This is the difference between the strike price of one share multiplied by 100 shares and
the market price of 100 shares of the stock on the expiration date of the option. The
option premium is not recognized.
Explanation for Choice C:
This is the market price of the 100 shares on the expiration date ($3,000) minus the
strike price of the 100 shares ($3,300) plus the option premium on 100 shares ($125).
This would be the loss of an investor who had gone short on an option with the given
characteristics.
Explanation for Choice D:
This is the market value of the 100 shares of stock on July 14 ($3,250) minus the strike
price of the option on the 100 shares ($3,300) plus the option premium ($125).
113. Question ID: HOCK RRI 20 (Topic: L-T Financial Management-Derivatives )
On July 14, an investor goes long on a put option for 100 shares of ZXY Corporation
common stock with a strike price of $33.00, expiring on August 16, at an option
premium of $1.25 per share. The market price of ZXY on July 14 is $32.50. On August
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16, the market price of ZXY is $35.00. How much has the investor gained or lost on the
option transaction? Disregard any brokerage commissions involved.

 A. Loss of $125.correct
 B. Gain of $125.
 C. Loss of $175.
 D. Gain of $250.
Question was not answered
Correct Answer Explanation:
The long party to an option is the one who purchases the option and who has the right
but not the obligation to exercise it. Here, the long party purchased a put option to sell
the stock at $33.00. On the expiration date, the stock’s market price is $35.00. The
investor who purchased the option to sell the stock at $33.00 will let the option expire,
because he would not sell stock at $33 when he could sell it at the market price of $35
instead. The option purchaser’s loss is the premium he paid for the option, which is
$1.25 multiplied by 100 shares, or $125.
Explanation for Choice B:
This is the gain that would have been earned by the short party to a transaction with
these characteristics.
Explanation for Choice C:
This is the market price of the 100 shares on July 14 ($3,250) minus the strike price of
the option multiplied by 100 shares ($3,300) plus the option premium ($125).
Explanation for Choice D:
This is the market price of 100 shares of the stock on August 16 ($3,500) minus the
market price of 100 shares of the stock on July 14 ($3,250).
114. Question ID: CIA 590 IV.57 (Topic: L-T Financial Management-Derivatives )
A company has recently purchased some stock of a competitor. However, it is
somewhat concerned that the market price of this stock could decrease over the short
run. The company could hedge against the possible decline in the stock's market price
by

 A. Purchasing a put option on that stock.correct

 B. Obtaining a warrant option on that stock.
 C. Purchasing a call option on that stock.
 D. Selling a put option on that stock.
Question was not answered
Correct Answer Explanation:
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A put option is the right to sell stock at a given price within a certain period. If the market
price falls, the put option may allow the sale of stock at a price above market, and the
profit of the option holder will be the difference between the price stated in the put
option and the market price, minus the cost of the option, commissions, and taxes.
Note that the company that issues the stock has nothing to do with put (and call) options
traded on the market by investors. It does not issue the options.
Explanation for Choice B:
A warrant gives the holder a right to purchase stock from the issuer at a given price. A
warrant is usually distributed by the issuing company along with debt. A warrant would
not provide a hedge against a decline in market price of the shares the company
already owns.
Explanation for Choice C:
A call option is the right to purchase shares at a given price within a specified period.
That would not provide a hedge against a decline in market price of the shares the
company already owns.
Explanation for Choice D:
Selling a put option would earn the company a little revenue from the sale. But it would
not provide a hedge against a possible decline in market value of the stock the
company already holds.
A put option gives the buyer the right (but not the obligation) to sell the underlying stock
at a specified price. The seller of the put option must buy the stock at that price if the
buyer of the put option exercises the option. If the market price of the stock drops below
the exercise price, the buyer of the put option will exercise the option, because the
buyer would be able to sell the stock for more by exercising the put than by selling the
stock on the open market. The seller of the put option would be required to buy the
stock at a price higher than the market price.
115. Question ID: HOCK RRI 102 (Topic: L-T Financial Management-Derivatives )
The difference between an American option and a European option is

 A. an American option is a covered option, whereas a European option is not.

 B. a European option is binding on both parties, whereas the long party in an American
option has the right but not the obligation to exercise the option.
 C. a European option is binding on both parties, whereas the short party in an American
option has the right but not the obligation to exercise the option.
 D. a European option can be exercised only on its maturity date, whereas an American
option can be exercised anytime up to and including its expiration date.correct
Question was not answered
Correct Answer Explanation:
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A European option can be exercised only on its maturity date, but an American option
can be exercised anytime up to and including its expiration date.
Explanation for Choice A:
This is not a true statement about American and European options.
Explanation for Choice B:
This is not a true statement about American and European options.
Explanation for Choice C:
This is not a true statement about American and European options.
116. Question ID: HOCK RRI 21 (Topic: L-T Financial Management-Derivatives )
On July 14, an investor goes short on a call option for 100 shares of CDM Corporation
common stock with a strike price of $70.00, expiring on August 16, at an option
premium of $3.00 per share. The market price of CDM on July 14 is $68.00. On August
16, the market price of CDM is $75.00. How much has the investor gained or lost on the
option transaction? Disregard any brokerage commissions involved.

 A. $200 gain.
 B. Loss of $500.
 C. Loss of $200.correct
 D. Gain of $300.
Question was not answered
Correct Answer Explanation:
The short party to an option is the one who sells the option and who must comply if the
buyer of the option chooses to exercise it. Here, the short party sold a call option to buy
the stock at $70.00. The buyer of the option has the right to buy the underlying stock
from the seller of the option at a price of $70.00. On the option’s expiration date, the
market price of CDM is $75.00. The buyer of the option exercises the option and buys
the CDM stock from the seller of the option. The seller of the option must purchase the
stock on the open market at $75.00 per share in order to sell it at $70.00 per share and
will have a $5.00 loss per share.
However, the seller received a premium of $3.00 per share for selling the option,
partially offsetting the loss. Therefore, the seller’s loss is $5.00 per share − $3.00 per
share, or $2.00 per share. Multiplied by 100 shares, the total loss is $200.00.
Explanation for Choice A:
This is the gain that would have been earned by the long party to a call option with the
same characteristics.
Explanation for Choice B:
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This is the strike price of $70 multiplied by 100 shares ($7,000) minus the market price
of 100 shares of the stock on the expiration date ($7,500).
Explanation for Choice D:
This is the gain that would have been earned by the short party to a put option with the
same characteristics. The option in this problem is a call option.
117. Question ID: CMA 696 1.8 (Topic: L-T Financial Management-Derivatives )
The current market price of ActionPharmaceutical's common stock is $34. A 6-month
call option has been written on the stock. The option has an exercise price of $40 and a
market value of $4. A financial analyst estimates that, at the end of 6 months, the
expected value of the stock is $42.
What is the value just prior to expiration of the option if the stock closes at $42 at the
end of 6 months?

 A. $0
 B. $4.00
 C. $6.00
 D. $2.00correct
Question was not answered
Correct Answer Explanation:
Just prior to its expiration the option has no time value left. Its only value will be its
intrinsic value, which is the amount by which the call option's strike price is lower than
the market price of the stock. Since the share can be purchased with the option for $40
and the expected market price at the end of the option period will be $42, the value of
the option is the difference between these amounts, or $2. If the price of the option is
more than $2, a person would be better off buying the share for $42 than buying the
option and then paying $40 for the share with the option.
Explanation for Choice A:
Since the market price is higher than the call price of the option, the option does have
some value. See the correct answer for a complete explanation.
Explanation for Choice B:
$4 is the market value of the option at the beginning of the 6 months. The question is
about the value of the option at the end of the six months.
Explanation for Choice C:
This answer is incorrect because at a price of the option of more than $2, the potential
shareholder would be better off buying the share in the market for $42 than paying $6
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for the option and then paying $40 for the share with the option. See the correct answer
for a complete explanation.
118. Question ID: ICMA 13.P2.022 (Topic: L-T Financial Management-Derivatives )
A gold mining company expects to sell 10,000 ounces of gold 6 months from today. The
revenue risk of selling the gold can be hedged by

 A. buying a gold futures contract for 5,000 ounces today that expires in 6 months, and
selling a gold futures contract for 5,000 ounces today that expires in 6 months.
 B. selling the gold in the spot market 6 months from today.
 C. selling a gold futures contract for 10,000 ounces today that expires in 6 months.correct
 D. buying a gold futures contract for 10,000 ounces today that expires in 6 months.
Question was not answered
Correct Answer Explanation:
A futures contract is an agreement to buy or sell a specified quantity of a specified asset
on a future date for a specified price. The gold mining company expecting to sell 10,000
ounces of gold in 6 months can sell a 6-month futures contract today in order to be
certain of the price it will receive. The gold mining company will be committed to
delivering the gold in 6 months, and the price it will receive is also committed because it
is stated in the contract. The futures contract will serve as a hedge for the revenue risk,
because regardless of what the market price is for the gold in 6 months, the mining
company will receive the revenue stated in the futures contract.
Whether the mining company benefits from the futures contract or loses money on the
contract depends upon the market price of gold in 6 months. If the market price is lower
than the contract price in 6 months, the mining company will receive the higher contract
price for the gold and will benefit. If the market price is higher than the contract price,
the mining company will also receive the contract price. The mining company will not be
able to benefit from the higher market price and thus will lose the difference between
the contract price and the higher market price. However, the mining company will have
locked in the revenue it will receive in 6 months for the sale of the gold and thus will
have eliminated the uncertainty of not knowing how much it will receive.
Explanation for Choice A:
This will accomplish nothing, because the purchase of the futures contract and the sale
of the same futures contract will cancel each other out. The mining company will have
nothing but some unnecessary brokerage costs.
Explanation for Choice B:
Selling the gold in the spot market 6 months from today would be no hedge at all,
because the gold would simply be sold at the market price in effect on that date. The
gold mining company would bear the revenue risk of selling at whatever the market
price is in 6 months.
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Explanation for Choice D:
Buying a gold futures contract for 10,000 ounces today that expires in 6 months would
commit the gold mining company to buying 10,000 ounces of gold in 6 months. It would
not serve to hedge the revenue risk of selling 10,000 ounces of gold in 6 months.
119. Question ID: CMA 696 1.9 (Topic: L-T Financial Management-Derivatives )
The current market price of ActionPharmaceutical's common stock is $34. A 6-month
call option has been written on the stock. The option has an exercise price of $40 and a
market value of $4. A financial analyst estimates that, at the end of 6 months, the
expected value of the stock is $42.
What is the theoretical value of exercising the option on the date it is written?

 A. $6.00
 B. $0correct
 C. $4.00
 D. $8.00
Question was not answered
Correct Answer Explanation:
At the time the option was written, it had no theoretical value. This is because the option
exercise price ($40) was higher than the market price ($34). Because of this, no one
would use the option to buy a share since it would be cheaper to buy a share on the
open market.
Explanation for Choice A:
This is the difference between the exercise price of the option and the current market
price of the stock. However, that is not the theoretical value of the option on the date it
is written.
Explanation for Choice C:
This is the market value of the option. However, the market value is not the same as the
theoretical value of the option on the date it is written.
Explanation for Choice D:
This is the difference between the expected market value of the stock and the current
market value of the stock. Howevr, this is not the theoretical value of the option on the
date it is written.
120. Question ID: HOCK RRI 12 (Topic: L-T Financial Management-Derivatives )
An agreement to exchange a fixed interest rate on a loan with a floating interest rate on
a loan is called a(n)
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Section B - Corporate Finance.
Answers
 A. basis swap.
 B. interest rate swap.correct
 C. interest rate guarantee.
 D. swaption.
Question was not answered
Correct Answer Explanation:
An interest rate swap takes place when two parties exchange interest payments, one at
a fixed rate and one at a floating (or variable) rate that is pegged to some sort of market
rate of interest and changes whenever the market rate changes. The primary purpose of
an interest rate swap is to match the characteristics of the firm's revenue stream with
the characteristics of its payment stream. For example, if a firm has a revenue stream
that increases or decreases with the market rate of interest, it would want its payment
stream to also increase or decrease with interest rates. If the firm has a fixed rate loan,
swapping the fixed rate loan for a floating rate loan would achieve this goal, and reduce
the firm's overall risk.
Explanation for Choice A:
A basis swap has is an interest rate swap with floating payments on both sides, each
tied to two different indexes. So a basis swap does not involve a fixed interest rate on
one side.
Explanation for Choice C:
An agreement to exchange a fixed interest rate on a loan with a floating interest rate on
a loan is not an interest rate guarantee.
Explanation for Choice D:
A swaption is an option to enter into a swap transaction at a specified future date, with
the terms of the swap being fixed at the time the swaption is transacted. A swaption
may be an option to enter into an agreement to exchange a fixed interest rate on a loan
with a floating interest rate on a loan. However, a swaption is not the agreement to do
so.
121. Question ID: HOCK RRI 17 (Topic: L-T Financial Management-Derivatives )
On July 14, an investor goes long on a call option for 100 shares of AMB Corporation
common stock with a strike price of $27.00, expiring on August 16, at an option
premium of $4.50 per share. The market price of AMB on July 14 is $31.00. On August
16, the market price of AMB is $35.00. How much has the investor gained or lost on the
option transaction? Disregard any brokerage commissions involved.

 A. $800 gain.
 B. $350 loss.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 C. $350 gain.correct
 D. $450 loss.
Question was not answered
Correct Answer Explanation:
The long party to an option is the one who purchases the option and who has the right
but not the obligation to exercise it. Here, the long party purchased a call option to buy
the stock at $27.00. On the expiration date, the stock’s market price is $35.00. The long
party has made money because he can buy the stock for $27.00 and resell it for $35.
However, the investor also has the premium he paid of $4.50 per share for the option to
consider. So his profit is $35.00 − $27.00 − $4.50 per share = $3.50 per share multiplied
by 100 shares, which is $350.
Explanation for Choice A:
This answer does not account for the option premium.
Explanation for Choice B:
This is the strike price of the 100 shares ($2,700) minus the market price of the 100
shares on the expiration date ($3,500) plus the price of the option on 100 shares ($450).
This would be the loss of an investor who had gone short on an option with the given
characteristics.
Explanation for Choice D:
This answer accounts for the option premium paid by the investor but not for the
difference between the exercise price of the option and the price of the underlying stock
on the expiration date.
122. Question ID: HOCK RRI 13 (Topic: L-T Financial Management-Derivatives )
A technique for managing interest rate risk based on measuring a bond's price
sensitivity to changes in interest rates is

 A. a forward contract.
 B. duration.correct
 C. interest rate futures.
 D. maturity matching.
Question was not answered
Correct Answer Explanation:
Interest rate risk is the change in value of a fixed income security that occurs as a result
of a change in market interest rates. If an investment in a fixed income security pays
interest at a rate that is less than the market rate of interest, that investment will be able
to be sold only if the price is discounted so that the effective rate is equal to the market
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Answers
rate of interest. The longer the maturity period of the investment, the greater the interest
rate risk as there is a longer investment horizon to be affected by the changes (up or
down) in interest rates. Therefore, prices of long-term bonds are more sensitive to
interest rate changes than short-term bonds.
Duration (also called Macaulay Duration) is a weighted average of the period of times
until the receipt of both the interest and the principal. Duration is a measure of bond
price sensitivity to interest rate changes. The longer a bond's duration, the greater its
sensitivity to interest rate changes. The numerator of the duration formula is the present
value of future payments discounted at the bond's yield to maturity and weighted by the
time until the payments will be received. The longer the intervals until payments are
made, the larger the numerator, and the longer the bond's duration. The denominator of
the duration formula is the discounted future cash flows that will be received from the
bond, discounted at the bond's yield to maturity, and thus is the present value of the
bond.
Explanation for Choice A:
A forward contract is an over-the-counter agreement between two parties to buy or sell
an asset at a certain time in the future for a certain price. It is not a technique for
managing interest rate risk based on measuring a bond's price sensitivity to changes in
interest rates.
Explanation for Choice C:
Interest rate futures are financial futures contracts on debt securities such as U.S.
Treasury securities. They do not measure a bond's sensitivity to changes in interest
rates.
Explanation for Choice D:
Maturity matching is used primarily by financial institutions that hold the majority of their
assets in liabilities in financial instruments. Maturity matching is a means of hedging
interest rate risk, but it involves more than simply measuring a bond's price sensitivity to
changes in interest rates.
Since the net worth of a financial institution is equal to its total assets less its total
liabilities, if a financial institution can equate the duration of its assets and the duration
of its liabilities, the bank can immunize its net worth against fluctuations due to changes
in interest rates. This is due to the fact that the total change in value for assets as a
result of a change in interest rates will be equivalent to the total change in value for
liabilities as a result of the change.
123. Question ID: ICMA 1603.P2.031 (Topic: L-T Financial Management-
Derivatives )
A Bangladeshi wholesale export company publishes a price list in Euros for the
products sold by its European Union business unit. The management of the export
company has determined that even if there are fluctuations in exchange rates between
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Answers
the Bangladeshi Taka and European Euro, it is not practical for it to change its product
prices every six months. Which one of the following is the most appropriate solution
available to the export company to managing this risk?

 A. Establishing operational sales limits.

 B. Diversifying its product offerings.
 C. Hedging the risk through financial instruments.correct
 D. Disposing of the business unit.
Question was not answered
Correct Answer Explanation:
Currency exchange rate risk can be managed through hedging the risk with financial
instruments such as such as forward contracts, futures contracts, currency options,
foreign exchange swaps and currency swaps.
Explanation for Choice A:
Establishing operational sales limits is not an appropriate way of managing currency
exchange rate risk.
Explanation for Choice B:
Diversifying product offerings is not an appropriate way of managing exchange rate risk.
Explanation for Choice D:
Disposing of the business unit is not an appropriate way of managing currency
exchange rate risk.
124. Question ID: HOCK RRI 14 (Topic: L-T Financial Management-Derivatives )
How is a futures contract closed out?

 A. The contract is returned to the party it was purchased from.

 B. Buyers and sellers usually offset their positions on or before the delivery date.correct
 C. On the maturity date, the underlying asset is purchased and delivery taken, or sold and
delivery made, by the holder of the contract.
 D. The contract expires on the maturity date, and there is no need to do anything to close
it out.
Question was not answered
Correct Answer Explanation:
Buyers and sellers of futures do not usually take delivery or make delivery of the
underlying asset. They simply offset their positions by the delivery date. For example,
someone who purchases Treasury bond futures contracts would simply sell similar
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Answers
futures contracts by the settlement date, the obligations would net to zero, and the
hedger or speculator would have either a gain or a loss on the transactions.
Explanation for Choice A:
A futures contract is not closed out by returning it to the party it was purchased from.
Explanation for Choice C:
Buyers and sellers of futures do not usually take delivery or make delivery of the
underlying asset.
Explanation for Choice D:
An option expires on its maturity date, and there is no need to do anything to close it
out. However, if a futures contract is not closed out by its maturity date, the holder of the
contract on its maturity date will be obligated to either purchase and take delivery of the
underlying asset, or sell and make delivery of the underlying asset.
125. Question ID: HOCK RRI 25 (Topic: L-T Financial Management-Derivatives )
On July 14, an investor goes short on a put option for 100 shares of OSC, Inc. common
stock with a strike price of $9.00, expiring on August 16, at an option premium of $1.50
per share. The market price of OSC on July 14 is $8.00. On August 16, the market price
of OSC is $11.00. How much has the investor gained or lost on the option transaction?
Disregard any brokerage commissions involved.

 A. Gain of $150.correct
 B. Gain of $200.
 C. Loss of $150.
 D. Loss of $50.
Question was not answered
Correct Answer Explanation:
The short party to an option is the one who sells the option and who must comply if the
buyer of the option chooses to exercise it. Here, the short party sold a put option, giving
the buyer of the put the option to sell the underlying stock at $9.
However, the market price of the stock on the expiration date is greater than $9, so the
buyer of the put option will not sell stock for $9 that he could instead sell on the open
market for $11.
Therefore, the buyer of the put option will let the option expire, and the seller of the
option gets to keep the premium of $1.50 per share received for having sold the option.
Thus, for 100 shares, the option seller’s gain is $150.
Explanation for Choice B:
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This is the market price of 100 shares on the option's expiration date ($1,100) minus the
strike price multiplied by 100 ($900).
The short party to an option is the one who sells the option and who must comply if the
buyer of the option chooses to exercise it. Here, the short party sold a put option, giving
the buyer of the put the option to sell the underlying stock at $9.
If the long party to the put option trade were to exercise the option and sell the stock to
the short party for $9 per share on the expiration date, the short party would have a gain
of $2 per share (or $200 on the trade) because the short party would be buying the
stock at $2 below market price. In addition, the short party would have the premium he
received for selling the put, which was $150, so the short party's total gain would
actually be $350.
However, that would never happen because the holder of the option would not sell the
stock at $2 below market price. The holder of the put option would never exercise the
option, and the option would just expire.
The seller of the put option (the short party) would be able to keep the premium
received for selling the option, however, and that would be the seller's gain.
Explanation for Choice C:
This is the loss that would be sustained by the long party to a put option transaction
with the same characteristics.
The long party to a put option is the one who has purchased the option. A put option
gives the buyer of the option the right but not the obligation to sell the underlying stock
at the strike price, here $9 per share.
On the expiration date of the option, the underlying stock's market price is $11 per
share. Therefore, the holder of the put option (the long party) will not exercise the option
because the holder can sell the stock at the market price instead, which is $2 greater
than the strike price of the put option. The holder of the put option will let the option
expire unexercised.
The long party's loss would be the amount he paid to buy the option, which at $1.50 per
share for 100 shares is $150.
However, this question is not about the gain or loss to the long party. This question is
about the gain or loss to the short party, the option seller. The option seller has a gain
equal to the amount of the premium he received for selling the put option.
Explanation for Choice D:
This is the loss that would be sustained by the short party to a call option transaction
with the same characteristics.
The short party to a call option is the one who sells a call, giving the buyer of the call the
right but not the obligation to buy the stock at the strike price, here $9 per share. The
 Hock P2 2020
Section B - Corporate Finance.
Answers
seller of the option, the short party, must sell the stock if the buyer of the option, the
long party, chooses to exercise the call option.
The market price on the expiration date is $11 per share. A call option for $9 per share
would be exercised because the buyer of the call option can purchase the stock for $9
per share when the market price is $11, so the buyer of the option will profit by buying
the stock at $2 less than the market price. The buyer of the call option's (the long
party's) net gain would be $200 less the $150 premium paid to buy the option, for a net
gain of $50.
The seller would have a $200 loss on the sale of the stock because of selling the stock
at $2 less than the market price. However, the seller of the call option would have
received $150 as the premium for selling the option. The seller's loss on the sale of the
stock would be offset by the $150 premium the seller received for selling the option, so
the seller's net loss on selling the call option would be $50.
However, that is not the scenario in this question. This question is about a put option,
not a call option.
126. Question ID: HOCK RRI 24 (Topic: L-T Financial Management-Derivatives )
On July 14, an investor goes short on a call option for 100 shares of CDM Corporation
common stock with a strike price of $70.00, expiring on August 16, at an option
premium of $3.00 per share. The market price of CDM on July 14 is $68.00. On August
16, the market price of CDM is $65.00. How much has the investor gained or lost on the
option transaction? Disregard any brokerage commissions involved.

 A. Gain of $200.
 B. Loss of $200.
 C. Gain of $300.correct
 D. Loss of $300.
Question was not answered
Correct Answer Explanation:
The short party to an option is the one who sells the option and who must comply if the
buyer of the option chooses to exercise it. Here, the short party sold a call option to buy
the stock at $70.00. The buyer of the option has the right to buy the underlying stock
from the seller of the option at the strike price of $70.00. On the option’s expiration date,
the market price of CDM is $65.00. The buyer of the option lets the option expire
because he would not pay $70.00 for a stock that he can buy on the open market at
$65.00. The seller of the option gets to keep the premium of $3.00 per share that he
received for selling the option, for a total gain of $300.
Explanation for Choice A:
This is the gain that would be earned by the long party to a put transaction with these
characteristics.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice B:
This would be the loss sustained by the short party to a put transaction with these
characteristics.
Explanation for Choice D:
This would be the loss sustained by a long party to a transaction with these
characteristics.
127. Question ID: HOCK RRI 15 (Topic: L-T Financial Management-Derivatives )
How is a forward contract closed out?

 A. The contract expires on the maturity date, and there is no need to do anything to close
it out.
 B. The contract is returned to the party it was purchased from.
 C. Buyers and sellers usually offset their positions on or before the delivery date.
 D. On the maturity date, the underlying asset is purchased and delivery taken or sold and
delivery made by the holder of the contract.correct
Question was not answered
Correct Answer Explanation:
A forward contract is settled at maturity by the sale and purchase of the commodity or
other asset. The original parties to the contract are obligated to complete the
transaction.
Explanation for Choice A:
A forward contract does not expire on its maturity date. The original parties to the
contract are obligated to complete the transaction on the maturity date.
Explanation for Choice B:
A forward contract is not closed out by returning it to the party it was purchased from.
Since forward contracts are not traded in secondary markets, there are no buyers or
sellers of forward contracts.
Explanation for Choice C:
Forward contracts cannot be traded in a secondary market, so there are no buyers and
sellers of forward contracts, and there is no opportunity to offset a position. The original
parties to a forward contract are obligated to complete the transaction.
128. Question ID: HOCK RRI 19 (Topic: L-T Financial Management-Derivatives )
On July 14, an investor goes long on a call option for 100 shares of AMB Corporation
common stock with a strike price of $27.00, expiring on August 16, at an option
premium of $4.50 per share. The market price of AMB on July 14 is $31.00. On August
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Section B - Corporate Finance.
Answers
16, the market price of AMB is $25.00. How much has the investor gained or lost on the
option transaction? Disregard any brokerage commissions involved.

 A. Loss of $250.
 B. Loss of $450.correct
 C. Gain of $150.
 D. Gain of $450.
Question was not answered
Correct Answer Explanation:
The long party to an option is the one who purchases the option and who has the right
but not the obligation to exercise it. Here, the long party purchased the call option to buy
the stock at $27.00. On the expiration date, the stock’s market price is $25.00. The
purchaser of the option will let the option expire because he would not buy the stock for
a price greater than the market price. So the option buyer’s loss is the premium he paid
for the option, which is $4.50 per share, multiplied by 100, or $450 in total.
Explanation for Choice A:
This is the strike price of the 100 shares ($2,700) minus the premium for the option
($450) minus the market price of the 100 shares on the expiration date ($2,500).
Explanation for Choice C:
This is the market price of the 100 shares ($3,100) on July 14 minus the option premium
of $450 minus the market price of the 100 shares on the expiration date ($2,500).
Explanation for Choice D:
This is the gain the short party would have earned on a transaction with these
characteristics.
129. Question ID: CMA 692 1.2 (Topic: Cost of Capital )
Williams, Inc. is interested in measuring its overall cost of capital and has gathered the
following data. Under the terms described as follows, the company can sell unlimited
amounts of all instruments.

 Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest
payments. In selling the issue, an average premium of $30 per bond would be
received, and the firm must pay flotation costs of $30 per bond. The after-tax cost
of funds is estimated to be 4.8%.
 Williams can sell $8 preferred stock at par value, $100 per share. The cost of
issuing and selling the preferred stock is expected to be $5 per share.
 Williams' common stock is currently selling for $100 per share. The firm expects to
pay cash dividends of $7 per share next year, and the dividends are expected to
 Hock P2 2020
Section B - Corporate Finance.
Answers
remain constant. The stock will have to be underpriced by $3 per share, and
flotation costs are expected to amount to $5 per share.
 Williams expects to have available $100,000 of retained earnings in the coming
year. Once these retained earnings are exhausted, the firm will use new common
stock as the form of common stock equity financing.
 The capital structure that Williams would like to use for any future financing is:
o Long-term debt: 30%
o Preferred stock: 20%
o Common stock: 50%
The cost of funds from retained earnings for Williams, Inc. is

 A. 7.4%.
 B. 8.1%.
 C. 7.0%.correct
 D. 7.6%.
Question was not answered
Correct Answer Explanation:
The three elements required to calculate the cost of retained earnings are (1) the
dividends per share, (2) the expected dividend growth rate, and (3) the market price of
the stock. Because growth in the dividend is not expected, the calculation is simply to
divide the dividend of $7 by the $100 market price of the stock to arrive at a cost of
retained earnings of 7%.
Explanation for Choice A:
This would be the cost of new common stock if the underpricing required were not
included in the calculation of the cost. However, the question asks for the cost of
retained earnings.
Explanation for Choice B:
This answer could result from using an anticipated growth rate in the dividend of 1.1%.
However, the dividends are expected to remain constant.
Explanation for Choice D:
This is the cost of new common stock, not the cost of retained earnings.
130. Question ID: ICMA 10.P2.121 (Topic: Cost of Capital )
Which one of the following situations would prompt a firm to issue debt, as opposed to
equity, the next time it raises external capital?

 A. Low fixed-charge coverage.

 Hock P2 2020
Section B - Corporate Finance.
Answers
 B. Significant percentage of assets under lease.
 C. High breakeven point.
 D. High effective tax rate.correct
Question was not answered
Correct Answer Explanation:
Dividends are paid after taxes, whereas interest expense is paid before taxes. The
effective interest rate is decreased because the company can deduct interest expense
before calculating its income tax due. A high effective tax rate makes this tax
deductibility of interest expense even more valuable.
Explanation for Choice A:
The fixed charge coverage ratio compares the funds available to pay fixed charges
(earnings before fixed charges and taxes) with the amount of fixed charges the
company has. Fixed charges include all contractually committed interest and principal
payments on both leases and debt. In financial statement analysis, this ratio gives an
indication of how much the company has available for the payment of its fixed charges
for leases and debt financing.
A low fixed charge coverage ratio would not prompt a firm to issue debt as opposed to
equity the next time it raises external capital.
Explanation for Choice B:
The amount of leased assets itself would not impact how new external capital is raised.
Capital structure would play a more significant role.
Explanation for Choice C:
This is not directly related to the generation of capital.
131. Question ID: ICMA 10.P2.133 (Topic: Cost of Capital )
Joint Products Inc., a corporation with a 40% marginal tax rate, plans to issue
$1,000,000 of 8% preferred stock in exchange for $1,000,000 of its 8% bonds currently
outstanding. The firm’s total liabilities and equity are equal to $10,000,000. The effect
of this exchange on the firm’s weighted average cost of capital is likely to be

 A. no change, since it involves equal amounts of capital in the exchange and both
instruments have the same rate.
 B. a decrease, since a portion of the debt payments are tax deductible.
 C. an increase, since a portion of the debt payments are tax deductible.correct
 D. a decrease, since preferred stock payments do not need to be made each year,
whereas debt payments must be made.
Question was not answered
 Hock P2 2020
Section B - Corporate Finance.
Answers
Correct Answer Explanation:
All other things being equal, the effect of issuing preferred stock in exchange for long-
term debt will be an increase in Joint Products' cost of capital, because interest on debt
is tax-deductible and that lowers its effective cost. So by decreasing the proportion of
debt in its capital structure, Joint Products will increase its weighted average cost of
capital.
However, there should also be a decrease in the company's cost of capital that will at
least partially offset the increase, because investors may perceive less risk in investing
in Joint Products due to the decreased financial leverage in its capital structure.
Whether the WACC increase because of the decreased proportion of debt in the capital
structure or the WACC decrease because of the decreased financial leverage will be
greater, leading to a net increase or a net decrease in the WACC, will depend on the
magnitude of each change.
Explanation for Choice A:
There will be a change in the company's weighted average cost of capital as a result of
exchanging debt instruments for preferred equity instruments.
Explanation for Choice B:
The debt payments are tax deductible, whereas dividend payments are not. However,
reducing debt and increasing equity by issuing preferred stock in exchange for debt
instruments will not cause a decrease in the weighted average cost of capital.
Explanation for Choice D:
This answer is partially true, though it is not the best answer. It is true that one of the
effects on the WACC should be a decrease in the company's cost of capital, but it is
because investors may perceive less risk in investing in Joint Products due to the
decreased financial leverage in its capital structure. However, this is not the only
change in the WACC that may take place as a result of issuing preferred stock in
exchange for long-term debt.
132. Question ID: CMA 690 1.10 (Topic: Cost of Capital )
Osgood Products has announced that it plans to finance future investments so that the
firm will achieve an optimum capital structure. Which one of the following corporate
objectives is consistent with this announcement?

 A. Minimize the cost of equity.

 B. Maximize earnings per share.
 C. Maximize the net worth of the firm.correct
 D. Minimize the cost of debt.
Question was not answered
 Hock P2 2020
Section B - Corporate Finance.
Answers
Correct Answer Explanation:
Financial structure is the composition of the financing sources of the assets of a firm.
Traditionally, the financial structure consists of current liabilities, long-term debt,
retained earnings, and stock. For most firms, the optimum structure includes a
combination of debt and equity. Debt is cheaper than equity, but excessive use of debt
increases the firm's risk and drives up the weighted-average cost of capital.
Explanation for Choice A:
Minimizing the cost of equity may signify overly conservative management.
Explanation for Choice B:
The maximization of EPS may not always suggest the best capital structure.
Explanation for Choice D:
Minimizing debt cost may not be optimal; as long as the firm can earn more on debt
capital than it pays in interest, debt financing may be indicated.
133. Question ID: ICMA 10.P2.129 (Topic: Cost of Capital )
An accountant for Stability Inc. must calculate the weighted average cost of capital of
the corporation using the following information.

Rate
Accounts payable $35,000,000 -0-
Long-term debt 10,000,000 8%
Preferred stock 10,000,000 15%
Retained earnings 5,000,000 18%
What is the weighted average cost of capital of Stability?

 A. 6.88%.
 B. 8.00%.
 C. 10.25%.
 D. 12.80%.correct
Question was not answered
Correct Answer Explanation:
The components of capital are long-term debt and equity, which includes both preferred
stock and common stock (retained earnings). Accounts payable is a current liability, and
it is not a component of capital or of the calculation of the cost of capital. The total of
long-term debt, preferred stock and retained earnings is $25,000,000. Therefore, the
 Hock P2 2020
Section B - Corporate Finance.
Answers
calculation of the company's weighted average cost of capital, based upon the
information given, is as follows

Long-term debt: 10/25 × 0.08 = 0.032

Preferred stock: 10/25 × 0.15 = 0.060
Retained earnings: 5/25 × 0.18 = 0.036
Weighted average cost of capital 0.128
Explanation for Choice A:
The weighted average cost of capital cannot be lower than the costs of the components
of capital. The costs of all of the components of capital are higher than 6.88%.
Explanation for Choice B:
This is the cost of the long-term debt. Long-term debt is not the only component of
capital.
Explanation for Choice C:
This is an unweighted average of the rates for accounts payable (0%), long-term debt
(8%), preferred stock (15%) and retained earnings (18%). There are two errors in this
answer: (1) the accounts payable should not be included, as accounts payable is short-
term debt and not capital; and (2) the costs of the other three components of capital
should be weighted according to each component's proportion of total capital.
134. Question ID: ICMA 10.P2.134 (Topic: Cost of Capital )
Cox Company has sold 1,000 shares of $100 par, 8% preferred stock at an issue price
of $92 per share. Stock issue costs were $5 per share. Cox pays taxes at the rate of
40%. What is Cox's cost of preferred stock capital?

 A. 8.70%.
 B. 8.25%.
 C. 9.20%.correct
 D. 8.00%.
Question was not answered
Correct Answer Explanation:
Cox Company will receive a net amount of $87 per share issued ($92 − $5). The
dividend due on the preferred stock will be 8% of the par value of $100 per share, which
is $8 (100 × 0.08). The cost of the preferred stock is the $8 dividend per share divided
by the $87 net proceeds per share, which is 0.09195 or 9.20%.
Explanation for Choice A:
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Section B - Corporate Finance.
Answers
This answer results from dividing the amount of the annual dividend to be paid per
share by the gross amount received from the sale of each share ($92). The annual
dividend per share should be divided by the net amount received from the sale of each
share (the gross amount minus the issue costs).
Explanation for Choice B:
This answer results from dividing the amount of the annual dividend to be paid per
share by the gross amount received from the sale of each share ($92) plus the issue
costs. The annual dividend per share should be divided by the net amount received
from the sale of each share (the gross amount minus the issue costs).
Explanation for Choice D:
8% is the amount of the dividend based on the par value of the stock ($100). The
annual dividend paid per share should be divided by the net amount received from the
sale of each share (the gross amount minus the issue costs).
135. Question ID: ICMA 1603.P2.018 (Topic: Cost of Capital )
A firm has $10 million in equity and $30 million in long-term debt to finance its
operations. The firm’s beta is 1.125, the risk-free rate is 6%, and the expected market
return is 14%. The firm issued long-term debt at the market rate of 9%. Assume the firm
is at its optimal capital structure. The firm’s effective income tax rate is 40%. What is the
firm’s weighted average cost of capital?

 A. 10.5%.
 B. 7.8%.correct
 C. 8.6%.
 D. 9.5%.
Question was not answered
Correct Answer Explanation:
The cost of equity is calculated using the Capital Asset Pricing Model: R = RF + β(RM −
RF).
R = 0.06 + 1.125(0.14 − 0.06)
R = 0.15
The after-tax cost of debt is the interest rate on the debt multiplied by 1 − the tax rate:
0.09(1 − 0.40) = 0.054
Total capital is $40 million ($10 million equity plus $30 million debt). Debt is 75% of total
capital ($30 million ÷ $40 million) and equity is 25% of total capital ($10 million ÷ $40
million). Therefore, the firm's weighted average cost of capital is
(0.75 × 0.054) + (0.25 × 0.15) = 0.078 or 7.8%.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice A:
This answer results from using the firm's cost of debt at its gross amount in calculating
the weighted average cost of capital. The firm's cost of debt should by reduced to its
tax-equivalent rate by multiplying it by 1 − the tax rate.
Explanation for Choice C:
This answer results from weighting the firm's equity at 33-1/3% and weighting the firm's
debt at 66-2/3% in calculating the weighted average cost of capital. The firm has $10
million in equity and $30 million in long-term debt, for total capital of $40 million. $10
million in equity is 25% of total capital while $30 million in debt is 75% of total capital.
Explanation for Choice D:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID and the actual incorrect
answer choice—not its letter, because that can change with every study session
created. The Question ID appears at the top of the question. Thank you in advance for
helping us to make your HOCK study materials better.
136. Question ID: ICMA 10.P2.138 (Topic: Cost of Capital )
Angela Company's capital structure consists entirely of long-term debt and common
equity. The cost of capital for each component is shown below.

Long-term debt 8%
Common equity 15%
Angela pays taxes at a rate of 40%. If Angela's weighted average cost of capital is
10.41%, what proportion of the company's capital structure is in the form of long-term
debt?

 A. 45%.correct
 B. 66%.
 C. 55%.
 D. 34%.
Question was not answered
Correct Answer Explanation:
The best way to solve this is to use algebra.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Let X = the proportion of debt (since that is what we are trying to find) and let (1 – X) =
the proportion of common equity. Since the cost of debt before tax is 8%, the after-tax
cost of debt is 0.08 × (1 − 0.40) = 0.048 or 4.8%.
The equation is: 0.048X + 0.15(1 − X) = 0.1041
Simplify: 0.048X + 0.15 − 0.15X = 0.1041
Combine like terms: −0.102X + 0.15 = 0.1041
Subtract 0.15 from both sides: −0.102X = –0.0459
Divide both sides by −0.102: X = 0.45
Since X = debt, the proportion of the company’s capital structure that is in the form of
long-term debt is 45%.
Explanation for Choice B:
This answer results from not decreasing the long-term debt rate of interest to the after-
tax rate of interest. The rate should be multiplied by 1 minus the tax rate to find the
after-tax rate.
Explanation for Choice C:
This is the proportion of common equity in Angela's capital structure.
Explanation for Choice D:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
137. Question ID: ICMA 10.P2.137 (Topic: Cost of Capital )
The management of Old Fenske Company (OFC) has been reviewing the company's
financing arrangements. The current financing mix is $750,000 of common stock,
$200,000 of preferred stock ($50 par) and $300,000 of debt. OFC currently pays a
common stock cash dividend of $2. The common stock sells for $38, and dividends
have been growing at about 10% per year. Debt currently provides a yield to maturity to
the investor of 12%, and preferred stock pays a dividend of 9% to yield 11%. Any new
issue of securities will have a flotation cost of approximately 3%. OFC has retained
earnings available for the equity requirement. The company's effective income tax rate
is 40%. Based on this information, the cost of capital for retained earnings is
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. 9.5%.
 B. 14.2%.
 C. 15.8%.correct
 D. 16.0%.
Question was not answered
Correct Answer Explanation:
To find the cost of retained earnings, we use the dividend growth model, which is C =
(d1/Pn) + g, where d1 represents the next dividend to be paid. The current year's dividend
is $2 and the growth rate is 10%, so the next dividend will be $2.20 ($2 × 1.10). The
stock price is $38. Therefore, ($2.20/$38) + 0.10 = 0.15789, which is 15.8%.
Explanation for Choice A:
This answer results from calculating the cost of retained earnings and then weighting it
according to the percentage of total capital represented by common stock.
Weighting of the various costs should be done in order to calculate the weighted
average cost of all the company's capital, but it should not be done to calculate the cost
of one single component of the WACC. In calculating the WACC, the various weighted
amounts are summed in order to calculate the overall weighted average cost of capital.
This question asks only for the cost of retained earnings, so all that is necessary is the
calculation of the cost of the retained earnings portion of the capital (unweighted).
Explanation for Choice B:
This is the weighted average cost of capital but calculated using the gross cost of debt,
not the after-tax net cost of debt. The cost of retained earnings is just one component of
the weighted average cost of capital.
Explanation for Choice D:
This is the cost of newly-issued common stock. Newly-issued common stock has
flotation costs, whereas there are no flotation costs for retained earnings.
138. Question ID: CMA 692 1.3 (Topic: Cost of Capital )
Williams, Inc. is interested in measuring its overall cost of capital and has gathered the
following data. Under the terms described as follows, the company can sell unlimited
amounts of all instruments.

 Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest
payments. In selling the issue, an average premium of $30 per bond would be
received, and the firm must pay flotation costs of $30 per bond. The after-tax cost
of funds is estimated to be 4.8%.
 Williams can sell $8 preferred stock at par value, which is $100 per share. The cost
of issuing and selling the preferred stock is expected to be $5 per share.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 Williams' common stock is currently selling for $100 per share. The firm expects to
pay cash dividends of $7 per share next year, and the dividends are expected to
remain constant. The stock will have to be underpriced by $3 per share, and
flotation costs are expected to amount to $5 per share.
 Williams expects to have available $100,000 of retained earnings in the coming
year. Once these retained earnings are exhausted, the firm will use new common
stock as the form of common stock equity financing.
 The capital structure that Williams would like to use for any future financing is:
o Long-term debt: 30%
o Preferred stock: 20%
o Common stock: 50%
If Williams, Inc. needs a total of $200,000, the firm's weighted marginal cost of capital
would be

 A. 6.9%.
 B. 4.8%.
 C. 20.2%.
 D. 6.6%.correct
Question was not answered
Correct Answer Explanation:
Williams' preferred capital structure for future financing includes 50% common stock.
$100,000 of retained earnings (50% of the required $200,000 of capital) will be used
before any common stock is issued. Thus, no new common stock will need to be
issued. The weighted marginal cost of capital will be determined based on the
respective costs of the bonds, preferred stock, and retained earnings. The after-tax cost
of the bonds is given as 4.8%. The cost of the preferred stock is 8.4%, calculated as the
annual dividend of $8 per share divided by the sale proceeds of $95. The cost of the
retained earnings to be used is 7% ($7 annual dividend divided by the $100 market
price of the common stock). These three costs are then weighted according to the
preferred capital structure ratios for new capital:

Long-term debt: 30% × 4.8% = 1.44%

Preferred stock: 20% × 8.4% = 1.68%
Common equity: 50% × 7.0% = 3.50%
Total (WMCC) 6.62%
Rounding to the nearest tenth produces the correct answer of 6.6%.
Explanation for Choice A:
 Hock P2 2020
Section B - Corporate Finance.
Answers
An answer of 6.9% can be obtained only if new common stock will be sold to fulfill the
common equity portion of the new capital. New stock will not be sold because the
company needs $200,000, of which 50%, or $100,000, will come from common equity.
There will be no need to sell stock when the total capital required is only $200,000.
Since the full $100,000 needed from common equity is available in retained earnings,
the company will use its retained earnings to fulfill the common equity portion of the
spending. The cost of the retained earnings is lower than the cost of new common
stock, because there are no issuance fees.
Explanation for Choice B:
4.8% is the cost of the long-term debt. All funding will not be obtained from debt
because the firm wants to maintain a capital structure in which debt represents only
30% of the total capital.
Explanation for Choice C:
20.2% represents the sum of the three elements of cost. What is needed is the
weighted average of the marginal costs of the three components of capital, weighted
according to each one's weight in the mix of total capital to be used in the new project.
139. Question ID: CMA 1294 1.28 (Topic: Cost of Capital )
By using the dividend growth model, estimate the cost of equity capital for a firm with a
stock price of $30.00, an estimated dividend at the end of the first year of $3.00 per
share, and an expected growth rate of 10%.

 A. 10.0%
 B. 11.0%
 C. 21.0%
 D. 20.0%correct
Question was not answered
Correct Answer Explanation:
The cost of common equity can be calculated with the following formula:

d1

Cre = +g
P0

Where:
Cre = Cost of retained earnings
d1 = The next dividend to be paid
 Hock P2 2020
Section B - Corporate Finance.
Answers
P0 = Common stock price today
g = Annual expected % growth in dividends
Note that the question says the estimated dividend at the end of the first year is $3.00
per share. Since the dividend is estimated, it is the next dividend to be paid and does
not need to be adjusted upward.
Inputting the information into this equation we get:

Cre = + 0.10 = 0.20, or 20.0%

30

Explanation for Choice A:

This is the growth rate of the dividend. It is also the amount of the dividend divided by
the stock price. However, neither of these is the cost of equity capital for this firm. See
the correct answer for a complete explanation.
Explanation for Choice B:
This answer results from increasing the $3.00 estimated dividend at the end of the first
year by 10% and dividing the result ($3.30) by the stock price ($30). This is incorrect for
two reasons: (1) The dividend to be used in the dividend growth model is
the next dividend to be paid. In this question, the next dividend to be paid is $3.00,
because that is the estimated dividend at the end of the first year. Therefore, it should
not be increased by 10% to $3.30. And (2) after dividing the next dividend by the stock
price, the result should be added to the expected growth rate to find the cost of common
equity.
Explanation for Choice C:
This answer results from increasing the estimated dividend at the end of the first year
($3.00 per share) by 10%. The dividend to be used in the dividend growth model is
the next dividend to be paid. In this question, the next dividend to be paid is $3.00,
because that is the estimated dividend at the end of the first year. Therefore, it should
not be increased by 10% to $3.30.
140. Question ID: HOCK RRI 111 (Topic: Cost of Capital )
A negative beta means

 A. that the security is risk-free.

 B. that the price of the security has tended to move in the opposite direction to that of the
market.correct
 C. that the security is less volatile than the market as a whole.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 D. that the security's return is negative.
Question was not answered
Correct Answer Explanation:
Securities with negative betas (less than zero) are extremely rare; however, they do
exist. A security with a negative beta is one that has historically tended to move against
the market—when the general market rises, the market price of a stock with a negative
beta goes down, and vice versa. A stock with a negative beta could be used to diversify
a portfolio because of its countertrend characteristics. Stocks of companies in
"defensive" industries such as consumer products and health care, as well as gold-
mining stocks, could be candidates to have negative betas.
Explanation for Choice A:
A risk-free security has a beta of zero. It does not have a negative beta.
Explanation for Choice C:
A stock with a negative beta could be just as volatile as the market as a whole. A stock
with a beta of −1 has the same amount of volatility as the market.
Explanation for Choice D:
A negative beta does not mean that the security's return is negative.
141. Question ID: ICMA 1603.P2.024 (Topic: Cost of Capital )
A company is in the process of considering various methods of raising additional capital
to grow the company. The current capital structure is 25% debt totaling $5 million with a
pre-tax cost of 10%, and 75% equity with a current cost of equity of 10%. The marginal
income tax rate is 40%. The company’s policy is to allow a total debt to total capital ratio
of up to 50% and a maximum weighted-average cost of capital (WACC) of 10%. The
company has the following options.
Option 1: Issue debt of $15 million with a pre-tax cost of 10%.
Option 2: Offer shares to the public to generate $15 million. The cost of equity is 10%.
Which option should the company select?

 A. Option 1 because it has the lower WACC of 7.72%.

 B. Either Option 1 or 2 because both will yield a WACC of 10%.
 C. Option 2 because the equity to total capital ratio will be 86%.correct
 D. Option 1 because the equity to total capital ratio will be 43%.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Currently, debt is $5 million and that is 25% of total capital, so total capital is $20 million
($5 million divided by 0.25). Equity is $15 million ($20 million total capital minus $5
million in debt).
If the company were to select Option 1, debt would become $20 million and total capital
would become $35 million, resulting in a debt to total capital ratio of 57%. That capital
structure would violate the company's policy of allowing a total debt to total capital ratio
of up to 50%. So Option 1 is not a viable option.
Option 2, issuing $15 million in new equity, will increase equity to $30 million and will
increase total capital to $35 million. Equity will be 86% of total capital ($30 million
divided by $35 million). Option 2 is the only option that does not violate the company's
policy of allowing a total debt to total capital ratio of up to 50%, so Option 2 should be
selected.
Explanation for Choice A:
The weighted average cost of capital is not relevant when considering Option 1 because
Option 1 would violate the company's policy of not allowing its total debt to total capital
ratio to go above 50%.
Currently, debt is $5 million and that is 25% of total capital, so total capital is $20 million
($5 million divided by 0.25). Issuing debt of $15 million will increase debt to $20 million
and increase total capital to $35 million. Debt will become 57% of total capital ($20
million divided by $35 million), which will violate the company's policy of allowing a total
debt to total capital ratio of up to 50%.
Therefore, Option 1 is not a viable option.
Explanation for Choice B:
The weighted average cost of capital is not relevant to this decision. What is relevant is
the company's capital structure. One of the options will violate the company's policy of
allowing a total debt to total capital ratio of up to 50%, so only one of the options is
viable.
Explanation for Choice D:
It is true that Option 1 would result in an equity to total capital ratio of 43%. However,
the total debt to total capital ratio will be 57%. A debt to total capital ratio of 57% would
violate the company's policy of allowing a total debt to total capital ratio of up to 50%.
Therefore, Option 1 is not a viable option.
142. Question ID: ICMA 10.P2.130 (Topic: Cost of Capital )
Kielly Machines Inc. is planning an expansion program estimated to cost $100 million.
Kielly is going to raise funds according to its target capital structure shown below.

Debt 0.30
 Hock P2 2020
Section B - Corporate Finance.
Answers
Preferred stock 0.24
Equity 0.46
Kielly had net income available to common shareholders of $184 million last year of
which 75% was paid out in dividends. The company has a marginal tax rate of 40%.
Additional data:

 The before-tax cost of debt is estimated to be 11%.

 The market yield of preferred stock is estimated to be 12%.
 The after-tax cost of common stock is estimated to be 16%.
What is Kielly's weighted average cost of capital?

 A. 13.00%.
 B. 14.00%.
 C. 13.54%.
 D. 12.22%.correct
Question was not answered
Correct Answer Explanation:
The before-tax cost of debt is given as 11%. The company's marginal tax rate is 40%.
Therefore, the after-tax cost of debt is 0.11 × (1 − 0.40), which is 0.066 or 6.6%. The
costs of the other components of the company's total capital to be raised are given in
the problem as 12% for preferred stock and 16% for common stock (retained earnings).
So the weighted average cost of capital is (0.30 × 0.066) + (0.24 × 0.12) + (0.46 × 0.16)
= 0.1222 or 12.22%.
Explanation for Choice A:
This is an unweighted average of the costs given in the problem. This is incorrect for
two reasons: (1) the average should be a weighted average, weighted according to
each component's percentage of the total capital; and (2) the cost of debt used is the
before-tax cost of debt instead of the after-tax cost of debt.
Explanation for Choice B:
This is an unweighted average of the costs of preferred stock and common stock. This
is incorrect for two reasons: (1) the average should be a weighted average, weighted
according to each component's percentage of the total capital; and (2) the cost of debt
is not included in the calculation.
Explanation for Choice C:
This answer results from using the before-tax cost of debt instead of the after-tax cost of
debt to calculate the weighted average cost of capital.
 Hock P2 2020
Section B - Corporate Finance.
Answers
143. Question ID: CMA 692 1.14 (Topic: Cost of Capital )
A preferred stock is sold for $101 per share, has a face value of $100 per share,
underwriting fees of $5 per share, and annual dividends of $10 per share. If the tax rate
is 40%, the cost of funds (capital) for the preferred stock is:

 A. 10.4%correct
 B. 10.0%
 C. 6.25%
 D. 4.2%
Question was not answered
Correct Answer Explanation:
Because the dividends on preferred stock are not deductible for tax purposes, the effect
of income taxes is ignored. Thus, the relevant calculation is to divide the $10 annual
dividend by the quantity of funds received at the time the stock is issued. In this case,
the funds received equal $96 ($101 selling price − $5 underwriting fee). Thus, the cost
of capital is 10.4% ($10 ÷ $96).
Explanation for Choice B:
This answer results from dividing the $10 dividend by the par value of the preferred
stock. The cost of new preferred stock should be based on the net funds received from
the issuance of the preferred stock, not on the par value of the stock issued.
Explanation for Choice C:
This is a $6 dividend divided by ($101 − $5). The annual dividend is $10 per share and
$10 should be used in the numerator.
A $6 dividend results from converting the dividend to an after-tax equivalent by
multiplying the annual dividend of $10 by (1 − the tax rate of 40%). Dividends are not
tax-deductible, so the amount of the dividend should not be converted to an after-tax
equivalent in this way.
Explanation for Choice D:
This is a $4 dividend divided by ($101 − $5). The annual dividend is $10 per share and
$10 should be used in the numerator.
A $4 dividend results from multiplying the annual dividend of $10 by the tax rate of 40%.
Dividends are not tax-deductible, and even if they were, multiplying the amount of the
dividend by the tax rate is not the correct way to calculate an after-tax equivalent. The
correct way to calculate an after-tax equivalent is to multiply the amount by (1 − the tax
rate).
144. Question ID: ICMA 10.P2.136 (Topic: Cost of Capital )
 Hock P2 2020
Section B - Corporate Finance.
Answers
The Hatch Sausage Company is projecting an annual growth rate for the foreseeable
future of 9%. The most recent dividend paid was $3.00 per share. New common stock
can be issued at $36 per share. Using the constant growth model, what is the
approximate cost of capital for retained earnings?

 A. 19.88%.
 B. 18.08%correct
 C. 17.33%.
 D. 9.08%.
Question was not answered
Correct Answer Explanation:
To answer this, we use the dividend growth model, also called the constant growth
model in the form Cre = (d1/P0) + g, where d1 is the next dividend to be paid. Since this
question gives the most recent dividend paid (i.e., the last historical dividend), we need
to increase it by 9% to get the next dividend to be paid. The next dividend will be $3 ×
1.09, or $3.27. Plugging the numbers into the formula, we get ($3.27 ÷ $36) + 0.09,
which is 0.1808 or 18.08%.
Explanation for Choice A:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice C:
This answer results from using the last dividend paid in the dividend growth model, also
called the constant growth model. The dividend growth model calls for the use of
the next dividend to be paid. Therefore, the last dividend paid needs to be increased by
the expected growth rate for one year to find the next dividend to be paid.
Explanation for Choice D:
This is the next dividend to be paid divided by the current stock price. The constant
growth model (or dividend growth model) calls for the growth rate to be added to that
quotient.
145. Question ID: ICMA 19.P2.075 (Topic: Cost of Capital )
 Hock P2 2020
Section B - Corporate Finance.
Answers
Four zero-coupon bonds each will pay $1,000 at maturity. The bonds mature in either
10 years or 20 years, and have a price today of either $300 or $500. The bond with the
largest yield to maturity is the bond that has the

 A. $300 price and matures in 10 years.correct

 B. $500 price and matures in 20 years.
 C. $300 price and matures in 20 years.
 D. $500 price and matures in 10 years.
Question was not answered
Correct Answer Explanation:
For each bond, calculate the amount of interest earned and received over the holding
period ($1,000 minus the purchase price) and the number of years the bond needs to
be held to receive that amount of interest. The highest yielding bond is the one that
pays the highest amount of interest over the shortest period of time.
Bond A: $700 interest in excess of the purchase price received in 10 years
Bond B: $500 interest in excess of the purchase price received in 10 years
Bond C: $700 interest in excess of the purchase price received in 20 years
Bond D: $500 interest in excess of the purchase price received in 20 years
The highest yielding bond is A because the investor will receive $700 for holding the
bond for 10 years. That combination is the highest interest received over the shortest
period of time. $700 is the higher amount of the two interest amounts, and the 10-year
holding period is the shorter holding period of the two holding periods.
Explanation for Choice B:
This is not the bond that has the largest yield to maturity. See the correct answer for a
complete explanation.
Explanation for Choice C:
This is not the bond that has the largest yield to maturity. See the correct answer for a
complete explanation.
Explanation for Choice D:
This is not the bond that has the largest yield to maturity. See the correct answer for a
complete explanation.
146. Question ID: CMA 690 1.15 (Topic: Cost of Capital )
In general, it is more expensive for a company to finance with equity capital than with
debt capital because
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. the interest on debt is a legal obligation.
 B. long-term bonds have a maturity date and must therefore be repaid in the future.
 C. investors are exposed to greater risk with equity capital.correct
 D. equity capital is in greater demand than debt capital.
Question was not answered
Correct Answer Explanation:
With equity capital (shares) investors are exposed to a greater risk because there is no
collateral supporting the investment and shareholders are last to receive money in the
case of liquidation. Because of these higher risks, the cost of equity is generally higher
than the cost of debt.
Explanation for Choice A:
Because the interest on the debt is a legal obligation, the debt holder has more certainty
that the interest will be paid. There is no obligation to pay anything to shareholders so
there is more risk for shareholders, which increase the cost of the equity.
Explanation for Choice B:
It is true that long-term bonds have a maturity date and must therefore be repaid in the
future. However, that is not the reason why it is more expensive for a company to
finance with equity capital than with debt capital.
Explanation for Choice D:
The demand for equity capital compared to the demand for debt depends on the
company that is issuing the equity and the debt.
147. Question ID: CIA 1191 IV.57 (Topic: Cost of Capital )
A firm seeking to optimize its capital budget has calculated its marginal cost of capital
and projected rates of return on several potential projects. The optimal capital budget is
determined by

 A. Calculating the point at which marginal cost of capital meets the projected rate of
return, assuming that the most profitable projects are accepted first.correct
 B. Accepting all potential projects with projected rates of return lower than the highest
marginal cost of capital.
 C. Calculating the point at which average marginal cost meets average projected rate of
return, assuming the largest projects are accepted first.
 D. Accepting all potential projects with projected rates of return exceeding the lowest
marginal cost of capital.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
In economics, a basic principle is that a firm should increase output until marginal cost
equals marginal revenue. Similarly, the optimal capital budget is determined by
calculating the point at which marginal cost of capital (which increases as capital
requirements increase) and the marginal efficiency of investment (which decreases if
the most profitable projects are accepted first) intersect.
Explanation for Choice B:
Accepting projects with rates of return lower than the cost of capital is not economically
rational business.
Explanation for Choice C:
The intersection of average marginal cost with average projected rates of return when
the largest (not the most profitable) projects are accepted first offers no meaningful
capital budgeting conclusion.
Explanation for Choice D:
Optimal capital budgeting assumes that the most profitable projects will be accepted
first and that the marginal cost of capital increases as capital requirements increase.
Thus, it is possible for the optimal capital budget to exclude profitable projects as lower
cost capital goes first to projects with higher rates of return.
148. Question ID: CMA 690 1.13 (Topic: Cost of Capital )
Colt, Inc. is planning to use retained earnings to finance anticipated capital
expenditures. The beta coefficient for Colt's stock is 1.15, the risk-free rate of interest is
8.5%, and the market return is estimated at 12.4%. If a new issue of common stock
were used in this model, the flotation costs would be 7%. By using the Capital Asset
Pricing Model (CAPM) equation:
R = RF + β(RM - RF)
The cost of using retained earnings to finance the capital expenditures is:

 A. 12.99%.correct
 B. 14.71%.
 C. 13.96%.
 D. 12.40%.
Question was not answered
Correct Answer Explanation:
The information on flotation costs in the question is not relevant to the calculation that
needs to be done. All we need to do is put the information into the CAPM formula that is
given in the problem. This gives us: 8.5% + [1.15 × (12.4% − 8.5%)] = 12.99% as the
cost of retained earnings.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice B:
This answer results from using the flotation cost as RF in the Capital Asset Pricing
Model. The information on flotation in the question is not relevant to the calculation that
needs to be done.
Explanation for Choice C:
This is the cost of retained earnings divided by 100% minus the flotation cost of 7%.
The information on flotation costs is not relevant to the calculation that needs to be
done. Using retained earnings does not involve issuing new equity and thus no flotation
costs are incurred.
Explanation for Choice D:
This is the market rate of interest, not the cost of the retained earnings.
149. Question ID: CMA 690 1.17 (Topic: Cost of Capital )
Enert, Inc.'s current capital structure is shown below. This structure is optimal, and the
company wishes to maintain it.

Debt 25%
Preferred equity 5%
Common equity 70%
Enert's management is planning to build a $75 million facility that will be financed
according to this desired capital structure. Currently, $15 million of cash is available for
capital expansion. The percentage of the $75 million that will come from a new issue of
common stock is:

 A. 52.50%.
 B. 56.00%.correct
 C. 70.00%.
 D. 50.00%.
Question was not answered
Correct Answer Explanation:
Of the $75 million needed, the company already has $15 million. Therefore, they need
to raise $60 million more. Of this, 70%, or $42 million will come from a new issuance of
common equity. This is 56% ($42 million ÷ $75 million) of the total amount that is
needed.
The new capital must be allocated in this way in order to maintain the same capital
structure as the company presently has. If the allocation of the new capital were to
include the retained earnings available, the company's capital structure would change
as a result of the new financing. Unlike new capital, retained earnings does not increase
 Hock P2 2020
Section B - Corporate Finance.
Answers
when it is used for a new project. Therefore, the amount of funding allocated to come
from retained earnings would not represent any increase in retained earnings or in total
capital. As a result, the proportion represented by each type of capital in the company's
overall capital structure would change if the total amount of funding, including the
amount to come from retained earnings, were used to determine the percentage of the
total funding to come from new common stock.
Explanation for Choice A:
This answer results from multiplying 70% by the total project funding of $75,000,000
and using the result, $52,500,000, as the answer in percentage form. To answer this
question, it is necessary to calculate the amount of funding to come from the new issue
of common stock and then divide that amount by the $75,000,000 to calculate the
percentage of the $75 million that will come from the new issue of common stock.
Explanation for Choice C:
This is the percentage of total capital that the company wants to maintain in common
equity. It is not the percentage of the total project funding that should come from a new
issue of common stock.
Explanation for Choice D:
This answer results from multiplying 70% by the total project funding of $75,000,000,
then subtracting from the resulting $52,500,000 the $15,000,000 in cash available. The
result, $37,500,000, divided by the total need of $75,000,000 equals 50%.
However, a new issue of common stock in the amount of $37,500,000 would change
the capital structure, reducing the percentage of common equity to total capital. In order
to maintain the same capital structure after the financing, the amount allocated to a new
issue of common stock should be 70% of the external financing needed. The reason is
because the $15,000,000 cash to be used is in retained earnings in the capital
structure, and retained earnings will not change as a result of the financing.
150. Question ID: ICMA 10.P2.135 (Topic: Cost of Capital )
In calculating the component costs of long-term funds, the appropriate cost of retained
earnings, ignoring flotation costs, is equal to

 A. the cost of common stock.correct

 B. the same as the cost of preferred stock.
 C. the weighted average cost of capital for the firm.
 D. zero, or no cost.
Question was not answered
Correct Answer Explanation:
The cost of retained earnings is the cost of common equity, because the common
shareholders are the owners of the company and they own the retained earnings even
 Hock P2 2020
Section B - Corporate Finance.
Answers
though the retained earnings have not been paid out to them as dividends. Retained
earnings are earnings that have been reinvested in the company that the common
shareholders own.
The cost of retained earnings to the company is the opportunity cost of the next best
investment that was not made by the shareholders. It is the return that the shareholders
of the company could have earned had they received all the profit in the form of a
dividend and invested that money somewhere else.
By retaining the profits within the company, the firm is investing those profits back into
the company on behalf of the existing shareholders. The shareholders will still demand
an adequate return on their reinvested cash, even though it is in the form of retained
earnings. If the shareholders believe the reinvested cash is not earning an adequate
return, they will sell their shares in order to put their investment funds to better use
elsewhere.
Explanation for Choice B:
The cost of retained earnings is not the same as the cost of preferred stock. The
common shareholders are the owners of the company and they own the retained
earnings.
Explanation for Choice C:
The cost of retained earnings is not the same as the weighted average cost of capital
for the firm. The cost of retained earnings is only one component of the weighted
average cost of capital for the firm.
Explanation for Choice D:
The cost of retained earnings is not zero, even though it is not a cash cost that is paid in
the form of dividends or interest.
The cost of retained earnings to the company is the opportunity cost of the next best
investment that was not made by the shareholders. It is the return that the shareholders
of the company could have earned had they received all the profit in the form of a
dividend and invested that money somewhere else.
By retaining the profits within the company, the firm is investing those profits back into
the company on behalf of the existing shareholders. The shareholders will still demand
an adequate return on their reinvested cash, even though it is in the form of retained
earnings. If the shareholders believe the reinvested cash is not earning an adequate
return, they will sell their shares in order to put their investment funds to better use
elsewhere.
151. Question ID: CMA 1294 1.27 (Topic: Cost of Capital )
DQZ Telecom is considering a project for the coming year that will cost $50 million.
DQZ plans to use the following combination of debt and equity to finance the
investment.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 Issue $15 million of 20-year bonds at 101, with a coupon rate of 8%, and flotation
costs of 2% of par.
 Use $35 million of funds generated from earnings.
 The equity market is expected to earn 12%. U.S. Treasury bonds are currently
yielding 5%. The beta coefficient for DQZ is estimated to be 0.60. DQZ is subject to
an effective corporate income tax rate of 40%.
The capital asset pricing model (CAPM) computes the expected return on a security by
adding the risk-free rate of return to the incremental yield of the expected market return,
which is adjusted by the company's beta. Compute DQZ's expected rate of return.

 A. 7.20%
 B. 12.20%
 C. 9.20%correct
 D. 12.00%
Question was not answered
Correct Answer Explanation:
The formula for the Capital Asset Pricing Model is
r = rf + β(rm − rf)
where r is the expected return, rm is the market rate of return, and rf is the risk-free rate.
Since this question asks for the calculation of the expected return, you merely need to
insert the numbers given in the problem into the CAPM formula and calculate r. All of
the information that would lead to calculation of the weighted average cost of capital is
unnecessary to answer the question.
The market return (rm) is given as 12%. The risk-free rate (rf) is the current yield on U.S.
Treasury Bonds, which is given as 5%. The beta (β) is given as 0.60. Therefore,
investors' expected rate of return for this company is
r = 0.05 + 0.6(0.12 − 0.05)
r = 0.092 or 9.2%
Explanation for Choice A:
An answer of 7.20% results from multiplying the market rate of 12% by 60%. However,
the expected return is calculated using the Capital Asset Pricing Model.
Explanation for Choice B:
An answer of 12.20% results from multiplying the market rate by 60% and adding that to
the risk-free rate. However, the expected return is calculated using the Capital Asset
Pricing Model.
Explanation for Choice D:
 Hock P2 2020
Section B - Corporate Finance.
Answers
12.00% is the market rate. However, the expected return is calculated using the Capital
Asset Pricing Model.
152. Question ID: ICMA 19.P2.074 (Topic: Cost of Capital )
The capital structure of an airline company is comprised of 50% common stock, 30%
preferred stock, and 20% debt. The company’s cost of common stock is 12%, and the
cost of preferred stock is 10%. The company’s pretax cost of debt is 5%. The company
has an effective income tax rate of 30%. What is the company’s weighted average cost
of capital?

 A. 9.7%.correct
 B. 18.9%.
 C. 8.8%.
 D. 10.0%.
Question was not answered
Correct Answer Explanation:
This is a simple weighted average calculation, but we need to remember to adjust the
pre-tax cost of debt to be the after-tax cost of debt. This is done by multiplying the 5%
pre-tax cost of debt by .7 (1 - the tax rate of .3), and getting the after-tax cost of debt of
3.5%.
To calculate the weighted average cost of capital we multiply the cost of each source of
financing by the % of the total financing that that type of financing represents.

Common stock .5 x .12 = .06

Preferred stock .3 x .10 = .03
Debt .2 x .035 = .007
Total .097
Adding the three amounts together gives a weighted average cost of capital of 9.7%
Explanation for Choice B:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice C:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice D:
This answer does not calculate the after-tax cost of debt and incorrectly uses the pre-
tax cost of debt in the calculation. See the correct answer for a complete explanation.
153. Question ID: CMA 1280 1.11 (Topic: Cost of Capital )
The DCL Corporation is preparing to evaluate the capital expenditure proposals for the
coming year. Because the firm employs discounted cash flow methods of analyses, the
cost of capital for the firm must be estimated. The following information for DCL
Corporation is provided:

 Market price of common stock is $50 per share.

 The dividend next year is expected to be $2.50 per share.
 Expected growth in dividends is a constant 10%.
 New bonds can be issued at face value with a 13% coupon rate.
 The current capital structure of 40% long-term debt and 60% equity is considered
to be optimal.
 Anticipated earnings to be retained in the coming year are $3 million.
 The firm has a 40% marginal tax rate.
If the firm must assume a 10% flotation cost on new stock issuances, what is the cost of
new common stock?

 A. 15.56%.correct
 B. 15.00%.
 C. 16.11%.
 D. 15.05%.
Question was not answered
Correct Answer Explanation:
The cost of funds from the sale of new shares of stock can be calculated with the
following formula:
 Hock P2 2020
Section B - Corporate Finance.
Answers
d1

Cns = +g
Pn

Where:
Cns = Cost of the new issuance of common stock
d1 = The next dividend to be paid
Pn = Net proceeds of the issue (selling price minus issuance costs)
g = Annual expected % growth in dividends
Note that the dividend given as $2.50 per share is for the next year. Since it is for next
year and the formula calls for the next dividend to be paid, the dividend does not need
to be adjusted upward by one year's growth before it is used in the formula.
Inputting the information into this equation we get:

2.50

Cns = + 0.10 = 0.1556, or 15.56%

50 − (0.10 × 50)

Explanation for Choice B:

This answer does not include the 10% flotation costs. See the correct answer for a
complete explanation.
Explanation for Choice C:
This answer applies the dividend growth to next year's dividend, making next year's
dividend $2.75 instead of $2.50 as it is stated. See the correct answer for a complete
explanation.
Explanation for Choice D:
This answer uses the present value of the next year's dividend, instead of the cash
value. See the correct answer for a complete explanation.
154. Question ID: CMA 692 1.5 (Topic: Cost of Capital )
Using the Capital Asset Pricing Model (CAPM), the required rate of return for a firm with
a beta of 1.25 when the market return is 14% and the risk-free rate is 6% is:

 A. 16.0%.correct
 B. 7.5%.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 C. 6.0%.
 D. 17.5%.
Question was not answered
Correct Answer Explanation:
To solve this problem, we simply need to put the variables into the CAPM formula,
which is
R = RF + β(RM − RF)
Substituting the values given into the formula gives a 16% rate of return: 0.06 + [1.25 ×
(0.14 − 0.06)] = 0.16 or 16%.
Explanation for Choice B:
This is the firm's beta multiplied by the risk-free rate.
The Capital Asset Pricing Model formula is:
R = RF + β(RM − RF)
Explanation for Choice C:
This is the risk-free rate, one component of the calculation of the required rate of return
using the Capital Asset Pricing Model.
The Capital Asset Pricing Model formula is:
R = RF + β(RM − RF)
Explanation for Choice D:
This is (1.25 × 0.06) + (1.25 [0.14 − 0.06]) = 0.175.
The Capital Asset Pricing Model formula is:
R = RF + β(RM − RF)
155. Question ID: CMA 1288 1.2 H1 (Topic: Cost of Capital )
When calculating a firm's cost of capital, all of the following are true except that

 A. The time value of money should be incorporated into the calculations.

 B. All costs should be expressed as after-tax costs.
 C. The calculation of the cost of capital should focus on the historical costs of alternative
forms of financing rather than market or current costs.correct
 D. The cost of capital of a firm is the weighted average cost of its various financing
components.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
The calculation of the cost of capital should focus on the current, after-tax costs of the
different sources of financing, not their historical costs; and it should use current market
values of the sources, not their book values.
Explanation for Choice A:
This is a true statement, so it is therefore incorrect since the question requires the
identification of the incorrect statement.
Explanation for Choice B:
This is a true statement, so it is therefore incorrect since the question requires the
identification of the incorrect statement.
Explanation for Choice D:
This is a true statement, so it is therefore incorrect since the question requires the
identification of the incorrect statement.
156. Question ID: CFM Sample Q. 9 (Topic: Cost of Capital )
Rogers Inc. operates a chain of restaurants located in the Southeast. The company has
steadily grown to its present size of 48 restaurants. The board of directors recently
approved a large-scale remodeling of the restaurant, and the company is now
considering two financing alternatives.
The first alternative would consist of

 Bonds that would have a 9% effective annual rate and would net $19.2 million after
flotation costs
 Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4%
flotation cost
 Common stock that would yield $24 million after a 5% flotation cost
The second alternative would consist of a public offering of bonds that would have an
11% effective annual rate and would net $48 million after flotation costs.
Rogers' current capital structure, which is considered optimal, consists of 40% long-term
debt, 10% preferred stock, and 50% common stock. The current market value of the
common stock is $30 per share, and the common stock dividend during the past 12
months was $3 per share. Investors are expecting the growth rate of dividends to equal
the historical rate of 6%. Rogers is subject to an effective income tax rate of 40%.
The after-tax weighted marginal cost of capital for Rogers' second financing alternative
consisting solely of bonds would be

 A. 5.40%
 B. 5.13%
 C. 6.60%correct
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Section B - Corporate Finance.
Answers
 D. 6.27%
Question was not answered
Correct Answer Explanation:
The after-tax cost of the bonds equals the before-tax interest rate times one minus the
tax rate, or 6.60% [11% x (100% − 40%)].
Explanation for Choice A:
5.40% is the effective annual rate of the bonds under the first alternative multiplied by 1
- the tax rate. The effective annual rate for the second financing alternative should be
used.
Explanation for Choice B:
5.13% is the effective annual rate of the bonds under the first alternative, multiplied by 1
- the tax rate, and then the rate is reduced by the 5% flotation costs. The effective
annual rate for the second financing alternative should be used, and the flotation costs
should not be subtracted.
Explanation for Choice D:
6.27% is the effective annual interest rate multiplied by 1 - the tax rate, and then the
rate is reduced by the 5% flotation costs. The flotation costs should not be subtracted.
157. Question ID: ICMA 19.P2.072 (Topic: Cost of Capital )
The yield curve shows the relationship between bond yields that differ by the

 A. credit risk of the issuer of the bonds.

 B. par value of the bonds.
 C. dividend yield of the issuer of the bonds.
 D. years to maturity of the bonds.correct
Question was not answered
Correct Answer Explanation:
By definition, the yield curve shows the relationship between interest rates on bonds
and the maturities of the bonds as of a moment in time.
Explanation for Choice A:
The yield curve does not show the credit risk of the issuer of the bonds.
Explanation for Choice B:
The yield curve does not show the par value of bonds.
Explanation for Choice C:
 Hock P2 2020
Section B - Corporate Finance.
Answers
The yield curve does not show the dividend yield of the issuer of the bonds.
158. Question ID: CMA 695 1.8 (Topic: Cost of Capital )
Below is a Statement of Financial Position for Martin Corporation:

Martin Corporation
Statement of Financial Position
(Dollars in millions)
Assets:
Current Assets $ 75
Plant and Equipment 250
Total Assets $325
Liabilities and shareholders' equity:
Liabilities:
Current Liabilities $ 46
Long-term debt (12%) 64
Common equity:
Common stock, $1 par $ 10
Additional paid in capital 100
Retained earnings 105
Total liabilities and shareholders' equity $325
Additional Data:

 The long term debt was originally issued at par ($1,000 per bond) and is currently
trading at $1,250 per bond.
 Martin Corporation can now issue debt at 150 basis points over U.S. treasury
bonds.
 The current risk-free rate (U.S. Treasury bonds) is 7%.
 The expected market return is currently 15%.
 The beta for Martin is 1.25.
 Martin's effective corporate income tax rate is 40%.
Using the Capital Asset Pricing Model (CAPM), Martin Corporation's current cost of
common equity is:
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Section B - Corporate Finance.
Answers
 A. 8.75%
 B. 15.00%
 C. 10.00%
 D. 17.00%correct
Question was not answered
Correct Answer Explanation:
The CAPM formula is: R = RF + β(RM − RF). The difference between the expected market
return and the risk-free rate multiplied by the company's beta is the individual security's
risk premium. To that, we add the risk-free rate to get the cost of the company's
common equity, which is the same thing as the investors' required rate of return for the
stock (R).
In this question all we need to do is to put the information from the question into the
formula. The risk free rate is 7%, the market rate is 15% and the beta for the company
is 1.25. This gives us: 0.07 + [1.25 (0.15 − 0.07)]. This is equal to 17%.
Explanation for Choice A:
This is the risk-free rate multiplied by the beta. The CAPM incorporates more
information than this. The CAPM formula is R = RF + β(RM − RF). β(RM − RF) is the
individual security's risk premium. To that, we add the risk-free rate to get the cost of the
company's common equity, which is the same thing as the investors' required rate of
return for the stock (R).
Explanation for Choice B:
This is simply the expected market return. The CAPM formula is R = RF + β(RM − RF).
The difference between the expected market return and the risk-free rate multiplied by
the company's beta is the individual security's risk premium. To that, we add the risk-
free rate to get the cost of the company's common equity, which is the same thing as
the investors' required rate of return for the stock (R).
Explanation for Choice C:
This answer does not add the risk free rate to the calculation of the individual security's
risk premium. The CAPM formula is R = RF + β(RM − RF). β(RM − RF) is the individual
security's risk premium. To that, we add the risk-free rate to get the cost of the
company's common equity, which is the same thing as the investors' required rate of
return for the stock (R).
159. Question ID: CIA 590 IV.49 (Topic: Cost of Capital )
A firm's optimal capital structure

 A. minimizes the firm's risk.

 B. maximizes the price of the firm's stock.correct
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Section B - Corporate Finance.
Answers
 C. minimizes the firm's tax liability.
 D. maximizes the firm's degree of financial leverage.
Question was not answered
Correct Answer Explanation:
The capital structure that maximizes the share price is the optimal capital structure. If
the share price is at its highest, that means that management has properly balanced the
risk and returns in its capital structure and investors value this structure the most.
Explanation for Choice A:
The lowest risk may not be the best capital structure for the company because the
lowest tax rate would be achieved with all equity financing. All equity financing may not
provide the lowest cost of capital and it may lead to investors not wanting to be owners
when the ownership share is so diluted from all of the shares that have been issued.
Explanation for Choice C:
The lowest tax liability may not be the best capital structure for the company because
the lowest tax rate would be achieved with all debt financing. All debt financing may not
provide the lowest cost of capital and it may lead to high levels of risk for the company
because of all of the fixed interest payments.
Explanation for Choice D:
The maximization of financial leverage would lead to high levels of risk and would
therefore probably not be the best capital structure.
160. Question ID: CMA 690 1.12 (Topic: Cost of Capital )
Acme Corporation is selling $25 million of cumulative, non-participating preferred stock.
The issue will have a par value of $65 per share with a dividend rate of 6%. The issue
will be sold to investors for $68 per share, and issuance costs will be $4 per share. The
cost of preferred stock to Acme is:

 A. 6.00%.
 B. 6.09%.correct
 C. 5.42%.
 D. 5.74%.
Question was not answered
Correct Answer Explanation:
The cost of the preferred stock is based on the amount that they will pay out as
dividends and the amount that is received from the sale. The company will receive only
$64 per share, but the dividend that they will pay is 6% of the $65 par value, or $3.90.
So the cost of the preferred shares is $3.90 ÷ $64, or 6.09%.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice A:
This is the stated rate of dividends that the preferred stock will pay. The cost needs to
be calculated using the dividends to be paid and the proceeds from the sale. See the
correct answer for a complete explanation.
Explanation for Choice C:
This answer has added the issue costs to determine the proceeds from the sale rather
than subtracting them. See the correct answer for a complete explanation.
Explanation for Choice D:
This answer does not subtract the issue costs from the sales price to calculate the
proceeds from the sale of the securities.
161. Question ID: CIA 1195 IV.43 (Topic: Cost of Capital )
When calculating the cost of capital, the cost assigned to retained earnings should be

 A. Lower than the cost of external common equity.correct

 B. Zero.
 C. Equal to the cost of external common equity.
 D. Higher than the cost of external common equity.
Question was not answered
Correct Answer Explanation:
Newly issued or external common equity is more costly than retained earnings. The
company incurs issuance costs when raising new, outside funds.
Explanation for Choice B:
The cost of retained earnings is the rate of return shareholders require on equity capital
the firm obtains by retaining earnings. The opportunity cost of retained funds should be
positive.
Explanation for Choice C:
Retained earnings will always be less costly than external equity financing because
earnings retention does not require the payment of issuance costs.
Explanation for Choice D:
Retained earnings will always be less costly than external equity financing because
earnings retention does not require the payment of issuance costs.
162. Question ID: CMA 690 1.14 (Topic: Cost of Capital )
Newmass, Inc. paid a cash dividend to its common shareholders over the past 12
months of $2.20 per share. The current market value of the common stock is $40 per
share, and investors are anticipating the common dividend to grow at a rate of 6%
 Hock P2 2020
Section B - Corporate Finance.
Answers
annually. The cost to issue new common stock will be 5% of the market value. The cost
of a new common stock issue will be

 A. 11.79%.
 B. 11.50%.
 C. 12.14%.correct
 D. 11.83%.
Question was not answered
Correct Answer Explanation:
The question says "Newmass, Inc. paid a cash dividend to its common
shareholders over the past 12 months of $2.20 per share." That means $2.20 is
a past dividend. The Dividend Growth Model requires the use of the next dividend − a
future dividend − so $2.20 must be increased by the dividend's expected growth rate of
6% before using it in the formula. $2.20 × 1.06 = $2.332 and we will use that as d1 in the
formula.
Here is the Dividend Growth Model formula. The cost of funds from the sale of new
shares of stock can be calculated with the following formula:

d1

Cns = +g
Pn

Where:
Cns = Cost of the new issuance of common stock
d1 = The next dividend to be paid
Pn = Net proceeds of the issue (selling price minus issuance costs)
g = Annual expected % growth in dividends
Inputting the information into this equation we get:

2.332

Cns = + 0.06 = 0.1214, or 12.14%

40 − (0.05 × 40)

Explanation for Choice A:

 Hock P2 2020
Section B - Corporate Finance.
Answers
This answer uses the current dividend instead of the next dividend. The question says
"Newmass, Inc. paid a cash dividend to its common shareholders over the past 12
months of $2.20 per share." That means $2.20 is a past dividend. The Dividend
Growth Model requires the use of the next dividend − a future dividend − so $2.20 must
be increased by the dividend's expected growth rate of 6% before using it in the
formula. See the correct answer for a complete explanation.
Explanation for Choice B:
This answer uses the current dividend instead of the next dividend and does not take
into account the flotation costs. The question says "Newmass, Inc. paid a cash dividend
to its common shareholders over the past 12 months of $2.20 per share." That means
$2.20 is a past dividend. The Dividend Growth Model requires the use of
the next dividend − a future dividend − so $2.20 must be increased by the dividend's
expected growth rate of 6% before using it in the formula. Also, the denominator needs
to be net of flotation costs. See the correct answer for a complete explanation.
Explanation for Choice D:
This answer does not take into account the flotation costs. The denominator of the
formula needs to be net of flotation costs. See the correct answer for a complete
explanation.
163. Question ID: ICMA 10.P2.131 (Topic: Cost of Capital )
Following is an excerpt from Albion Corporation's balance sheet.

Long-term debt (9% interest rate) $30,000,000

Preferred stock (100,000 shares, 12% dividend) 10,000,000
Common stock (5,000,000 shares outstanding) 60,000,000
Albion's bonds are currently trading at $1,083.34, reflecting a yield to maturity of 8%.
The preferred stock is trading at $125 per share. Common stock is selling at $16 per
share, and Albion's treasurer estimates that the firm's cost of equity is 17%. If Albion's
effective income tax rate is 40%, what is the firm's cost of capital?

 A. 13.1%correct
 B. 12.6%
 C. 13.9%
 D. 14.1%
Question was not answered
Correct Answer Explanation:
The weighted average cost of capital is calculated using market values of the
components of the capital.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Bonds are always issued in increments of $1,000 face value. So if a company has
$30,000,000 in bonds on its balance sheet, it has 30,000 bonds outstanding
($30,000,000 ÷ 1,000).
The market value of the company's bonds is 30,000 bonds × the market price of
$1,083.34, or $32,500,200.
The market value of the preferred stock is $125 × 100,000 shares, or $12,500,000.
The market value of the common stock is $16 × 5,000,000 shares outstanding, or
$80,000,000.
Thus, the company's total capital for the purpose of calculating its weighted average
cost of capital is $32,500,200 + $12,500,000 + $80,000,000, which equals
$125,000,200.
The cost of debt at market value is given as 8%. Therefore, we will use 8%, adjusted for
the tax deductibility of interest, as the cost of debt.
The cost of the preferred stock is 12% of $10,000,000, or $1,200,000. At a market value
of $12,500,000 (calculated above), the cost of the preferred stock is $1,200,000 ÷
$12,500,000, or 0.096 (9.6%).
The cost of the common stock is given as 17%.
Therefore, the calculation of the company's weighted average cost of capital, based
upon the information given, is as follows:

Long-term debt: $32,500,200 ÷ $125,000,200 × 0.08 × (1 − 0.40) = 0.01248

Preferred stock: $12,500,000 ÷ $125,000,200 × 0.096 = 0.00959
Common stock: $80,000,000 ÷ $125,000,200 × 0.17 = 0.10879
Weighted average cost of capital 0.13086
The rounded cost of capital is 13.1%.
Explanation for Choice B:
This answer results from using book values to calculate the weighted average cost of
capital. Market values, not book values, should be used.
Explanation for Choice C:
This answer results from using the market interest rate of 8% for debt without adjusting
it for the tax deductibility of interest by multiplying it by (1 − the tax rate).
Explanation for Choice D:
This answer results from using the market interest rate of 8% for debt without adjusting
it for the tax deductibility of interest by multiplying it by (1 − the tax rate) and from using
 Hock P2 2020
Section B - Corporate Finance.
Answers
the nominal dividend rate of 12% for the preferred stock instead of a dividend rate
calculated using the actual dividends paid per year divided by the market value of the
preferred stock.
164. Question ID: ICMA 19.P2.071 (Topic: Cost of Capital )
An investor is evaluating the common stock of a technology company which has a beta
of 1.8. The expected return for the securities market as a whole is 8%. The investor
could receive a risk- free return of 2% on a U.S. Treasury bill. Based on the capital
asset pricing model (CAPM), what is the expected risk adjusted return of the technology
company’s common stock?

 A. 16.4%.
 B. 20.0%.
 C. 10.8%.
 D. 12.8%.correct
Question was not answered
Correct Answer Explanation:
The requirement in this question is to input the information given into the CAPM formula
and then solve for the required return.
The CAPM formula is:
R = RF + β(RM − RF)
Entering the information from the question, we get:
R = .02 + (.08 - .02)
Solving for R, we get 12.8% and this is the expected risk-adjusted return for this stock.
Explanation for Choice A:
This choice does not apply the CAPM formula correctly. It does not subtract the risk-free
rate from the market rate before multiplying by Beta. See the correct answer for a
complete explanation.
Explanation for Choice B:
This choice does not apply the CAPM formula correctly. It adds the risk-free rate to the
market rate instead of subtracting it before multiplying by Beta. See the correct answer
for a complete explanation.
Explanation for Choice C:
This choice does not apply the CAPM formula correctly. It does not include the addition
of the risk-free rate in the calculation. See the correct answer for a complete
explanation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
165. Question ID: CMA 692 1.1 (Topic: Cost of Capital )
Williams, Inc. is interested in measuring its overall cost of capital and has gathered the
following data. Under the terms described as follows, the company can sell unlimited
amounts of all instruments.

 Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest
payments. In selling the issue, an average premium of $30 per bond would be
received, and the firm must pay flotation costs of $30 per bond. The after-tax cost
of funds is estimated to be 4.8%.
 Williams can sell $8 preferred stock at par value, $100 per share. The cost of
issuing and selling the preferred stock is expected to be $5 per share.
 Williams' common stock is currently selling for $100 per share. The firm expects to
pay cash dividends of $7 per share next year, and the dividends are expected to
remain constant. The stock will have to be underpriced by $3 per share, and
flotation costs are expected to amount to $5 per share.
 Williams expects to have available $100,000 of retained earnings in the coming
year. Once these retained earnings are exhausted, the firm will use new common
stock as the form of common stock equity financing.
 The capital structure that Williams would like to use for any future financing is:
o Long-term debt: 30%
o Preferred stock: 20%
o Common stock: 50%
The cost of funds from the sale of common stock for Williams, Inc. is

 A. 7.4%.
 B. 7.0%.
 C. 7.6%.correct
 D. 8.1%
Question was not answered
Correct Answer Explanation:
According to the Gordon growth model, the three elements required to calculate the
cost of new equity capital are (1) the dividends per share, (2) the expected dividend
growth rate, and (3) the expected selling price of the stock. If flotation costs are incurred
when issuing new stock, the flotation cost per share is deducted from the market price
to arrive at the amount of capital the corporation will actually receive. Accordingly, the
$100 per share selling price is reduced by the $3 discount for the underpricing and the
$5 flotation costs to arrive at $92 to be received for the each share of the new issue of
stock. Because the dividend is not expected to increase in future years, no growth factor
 Hock P2 2020
Section B - Corporate Finance.
Answers
is included in the calculation. Thus, the cost of the common stock is 7.6% ($7 dividend ÷
$92).
Explanation for Choice A:
This answer results from assuming that Williams will receive $95 per share from the
sale of the new stock. The current market value of the stock is $100 per share and
flotation costs are expected to amount to $5 per share. However, the new stock will also
have to be underpriced (priced below the market price), and that will further reduce the
amount the company will receive from the sale of the stock.
Explanation for Choice B:
This answer results from assuming that Williams will receive $100 per share from the
sale of the new stock. The current market value of the stock is $100 per share.
However, the new stock will have to be underpriced (priced below the market price),
and flotation costs will further reduce the amount the company will receive from the sale
of the stock.
Explanation for Choice D:
This answer could result from using $86.50 or some amount close to that as the cash
received from the sale of the new stock; or it could result from using a dividend growth
factor of 0.05% in calculating the cost of new equity. However, the company will receive
more than $86.50 from the sale of the stock, and the dividends are expected to remain
constant.
166. Question ID: CMA 1291 1.2 (Topic: Cost of Capital )
The explicit cost of debt financing is the interest expense. The implicit cost(s) of debt
financing is (are) the

 A. Increase in the cost of debt as the debt-to-equity ratio increases.

 B. Decrease in the cost of equity as the debt-to-equity ratio increases.
 C. Increase in the cost of equity as the debt-to-equity ratio decreases.
 D. Increases in the cost of debt and equity as the debt-to-equity ratio increases.correct
Question was not answered
Correct Answer Explanation:
An implicit cost is a cost that is not directly paid. In the issuance of debt, an implicit cost
is the cost of future debt and equity. As a company issues more debt, the cost of each
issuance increases because there is a greater risk of default by the company because
of the larger amount of debt that they have outstanding.
Explanation for Choice A:
Though this statement is correct, it is not as complete as one of the other choices. See
the correct answer for a complete explanation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice B:
The cost of debt will increase as the debt-to-equity ratio increases.
Explanation for Choice C:
The increase in the cost of equity will be an implicit cost of the issuance of debt, but it
occurs because the debt-to-equity ratio increases, not decreases.
167. Question ID: CFM Sample Q. 8 (Topic: Cost of Capital )
Rogers Inc. operates a chain of restaurants located in the Southeast. The company has
steadily grown to its present size of 48 restaurants. The board of directors recently
approved a large-scale remodeling of the restaurant, and the company is now
considering two financing alternatives.
The first alternative would consist of

 - Bonds that would have a 9% coupon rate and would net $19.2 million after
flotation costs
 - Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4%
flotation cost
 - Common stock that would yield $24 million after a 5% flotation cost
The second alternative would consist of a public offering of bonds that would have an
11% coupon rate and would net $48 million after flotation costs.
Rogers' current capital structure, which is considered optimal, consists of 40% long-term
debt, 10% preferred stock, and 50% common stock. The current market value of the
common stock is $30 per share, and the common stock dividend during the past 12
months was $3 per share. Investors are expecting the growth rate of dividends to equal
the historical rate of 6%. Rogers is subject to an effective income tax rate of 40%.
Assuming the after-tax cost of common stock is 15%, the after-tax weighted marginal
cost of capital for Rogers' first financing alternative consisting of bonds, preferred stock,
and common stock would be

 A. 7.285%
 B. 8.725%
 C. 10.285%correct
 D. 11.725%
Question was not answered
Correct Answer Explanation:
The cost of the bonds equals the interest rate times one minus the tax rate, or 5.4% [9%
× (100% − 40%)]. The cost of preferred stock equals the preferred dividend amount
divided by the net issuance price. No tax adjustment is necessary because preferred
 Hock P2 2020
Section B - Corporate Finance.
Answers
dividends paid are not tax deductible. The cost of the preferred stock is therefore 6% of
the par value of the preferred stock {[$4,800,000 net issuance price / (100% − 4%
flotation cost)] = $5,000,000 par value} divided by the net issuance price, or 6.25% [(6%
× $5,000,000) / $4,800,000]. The cost of the common stock is given as 15%.
So the weighted average is as follows:

Weighted
Weight Cost Average
Bonds 40% × 5.40% = 2.160%
Preferred Stock 10% × 6.25% = 0.625%
Common Stock 50% × 15.00% = 7.500%
--------
Weighted Average 10.285%
Explanation for Choice A:
This answer results from multiplying the cost of the common stock by 1 - the tax rate.
Dividends are not tax deductible, so the cost of common stock should not be adjusted to
any after-tax cost.
Explanation for Choice B:
This answer results from two errors: (1) failing to multiply the rate on the bonds by 1 -
the tax rate to calculate their after-tax cost; and (2) multiplying the rate for the common
stock by 1 - the tax rate. Dividends are not tax deductible, so the cost of common
stockshould not be adjusted to any after-tax cost.
Explanation for Choice D:
This answer results from failing to multiply the rate on the bonds by 1 - the tax rate to
get the after-tax cost.
168. Question ID: CMA 692 1.15 (Topic: Cost of Capital )
Which one of a firm's sources of new capital usually has the lowest after-tax cost?

 A. Bonds.correct
 B. Retained earnings.
 C. Common stock.
 D. Preferred stock.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Because bond interest is tax deductible and because bondholders have a priority claim
to the assets of the company, bonds usually have the lowest after-tax cost of the items
listed as choices.
Explanation for Choice B:
Dividends are not tax deductible and this connected with the costs of the issuance of
shares and the fact that shareholders are a lower priority in the case of liquidation
means that retained earnings is not the cheapest after-tax source of financing.
Explanation for Choice C:
Dividends are not tax deductible and this connected with the costs of the issuance of
shares and the fact that shareholders have a lower priority than bondholders in the case
of liquidation means that common stock is not the cheapest after-tax source of
financing.
Explanation for Choice D:
Dividends are not tax deductible and this connected with the costs of the issuance of
shares and the fact that shareholders have a lower priority than bondholders in the case
of liquidation means that preferred stock is not the cheapest after-tax source of
financing.
169. Question ID: CMA 692 1.4 (Topic: Cost of Capital )
Williams, Inc. is interested in measuring its overall cost of capital and has gathered the
following data. Under the terms described as follows, the company can sell unlimited
amounts of all instruments.

 Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest
payments. In selling the issue, an average premium of $30 per bond would be
received, and the firm must pay flotation costs of $30 per bond. The after-tax cost
of funds is estimated to be 4.8%.
 Williams can sell $8 preferred stock at par value, $100 per share. The cost of
issuing and selling the preferred stock is expected to be $5 per share.
 Williams' common stock is currently selling for $100 per share. The firm expects to
pay cash dividends of $7 per share next year, and the dividends are expected to
remain constant. The stock will have to be underpriced by $3 per share, and
flotation costs are expected to amount to $5 per share.
 Williams expects to have available $100,000 of retained earnings in the coming
year. Once these retained earnings are exhausted, the firm will use new common
stock as the form of common stock equity financing.
 The capital structure that Williams would like to use for any future financing is:
o Long-term debt: 30%
o Preferred stock: 20%
 Hock P2 2020
Section B - Corporate Finance.
Answers
o Common stock: 50%
If Williams, Inc. needs a total of $1,000,000, the firm's weighted marginal cost of capital
would be

 A. 27.8%.
 B. 6.6%.
 C. 6.9%.correct
 D. 4.8%.
Question was not answered
Correct Answer Explanation:
The after-tax cost of the bonds is given as 4.8%. The cost of the preferred stock is
8.4%, calculated as the annual dividend of $8 per share divided by the sale proceeds of
$95. The cost of the retained earnings is 7% ($7 annual dividend divided by the $100
market price of the common stock). The cost of new common stock is 7.6% ($7 dividend
divided by the $92 net proceeds from the sale). Retained earnings of $100,000 will be
used to fulfill the common stock portion of the capital before any new common stock is
sold.
The common equity portion of all of the funding is 50% of $1,000,000, or $500,000.
Since $100,000 of that will come from retained earnings, that leaves $400,000 or 40%
of the total funding that will need to come from the issuance of new common stock.
The weighted marginal cost of capital will be:

Long-term debt 30% × 0.048 = 1.44%

Preferred stock 20% × 0.084 = 1.68%
Retained earnings 10% × 0.07 = 0.70%
New common stock 40% × 0.076 = 3.04%
WMCC 6.86%
Rounding to the nearest tenth of one percent results in the correct answer of 6.9%.
Explanation for Choice A:
27.8% represents the sum of the four elements of cost. What is needed is the weighted
average of the marginal costs of the four components of capital, weighted according to
each one's weight in the mix of total capital to be used in the new project.
Explanation for Choice B:
6.6% would be correct only if the equity capital were obtained totally from retained
earnings. Because only $100,000 of retained earnings is available, the remainder of the
equity capital must come from sale of new stock.
 Hock P2 2020
Section B - Corporate Finance.
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Explanation for Choice D:
4.8% is given as the cost of the long-term debt.
170. Question ID: ICMA 10.P2.132 (Topic: Cost of Capital )
Thomas Company's capital structure consists of 30% long-term debt, 25% preferred
stock, and 45% common equity. The cost of capital for each component is shown
below.

Long-term debt 8%
Preferred stock 11%
Common equity 15%
If Thomas pays taxes at the rate of 40%, what is the company's after-tax weighted
average cost of capital?

 A. 9.84%.
 B. 7.14%.
 C. 11.90%.
 D. 10.94%.correct
Question was not answered
Correct Answer Explanation:
The after-tax cost of long-term debt for Thomas is 0.08 × (1 − 0.40), which is 0.048. The
cost for the preferred stock and common equity do not need to be adjusted the way the
cost of debt is, because dividends are not tax deductible, whereas interest on debt is tax
deductible. Therefore, the after-tax weighted average cost of capital for the company is
(0.30 × 0.048) + (0.25 × 0.11) + (0.45 × 0.15) = 0.1094 or 10.94%.
Explanation for Choice A:
This answer results from multiplying the rates for the long-term debt and preferred stock
by (1 − 0.40) to reflect their tax deductibility. However, only interest expense is tax
deductible. Dividends (neither preferred nor common) are not tax deductible and thus
should not be multiplied by (1 − 0.40).
Explanation for Choice B:
This answer results from multiplying the rates for the long-term debt, preferred stock
and common equity by (1 − 0.40) to reflect their tax deductibility. However, only interest
expense is tax deductible. Dividends are not tax deductible and thus should not be
multiplied by (1 − 0.40).
Explanation for Choice C:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This answer results from failing to adjust the interest rate of the long-term debt to reflect
its tax deductibility. The interest rate for the debt should be multiplied by (1 − 0.40)
because interest is tax deductible, which decreases its cost.
171. Question ID: CMA 690 1.18 (Topic: Cost of Capital )
Datacomp Industries, which has no current debt, has a beta of 0.95 for its common
stock. Management is considering a change in the capital structure to 30% debt and
70% equity. This change would increase the beta on the stock to 1.05, and the after-tax
cost of debt will be 7.5%. The expected return on equities is 16%, and the risk-free rate
is 6%. Should Datacomp's management proceed with the capital structure change?

 A. No, because the weighted average cost of capital will increase.

 B. Yes, because there will be no effect on the weighted average cost of capital.
 C. Yes, because the weighted average cost of capital will decrease.correct
 D. No, because the cost of equity capital will increase.
Question was not answered
Correct Answer Explanation:
Using the CAPM formula, which is r = rF + β(rM − rF), we can determine that the current
cost of capital consisting only of equity for the firm is 15.5%:
r = 0.06 + 0.95(0.16 − 0.06) = 0.155.
The proposed capital structure will have an after tax cost equal to 13.8%:
(0.3 × 0.075) + (0.7 × [0.06 + 1.05(0.16 − 0.06)]) = 0.138.
So, the company should proceed with the capital change as it will reduce the WACC
from 15.5% to 13.8%.
Explanation for Choice A:
The weighted average cost of capital will decrease if this change is made, so the
change should be made. See the correct answer for a complete explanation.
Explanation for Choice B:
Though the change should be made, this reason for making the change is incorrect.
The change should be made because the weighted average cost of capital will
decrease. If the weighted average cost of capital will remain the same, there is no need
to make the change.
Explanation for Choice D:
The weighted average cost of capital will decrease if this change is made, so the
change should be made. See the correct answer for a complete explanation.
172. Question ID: ICMA 10.P2.128 (Topic: Cost of Capital )
 Hock P2 2020
Section B - Corporate Finance.
Answers
Which of the following, when considered individually, would generally have the effect of
increasing a firm's cost of capital?

I. The firm reduces its operating leverage.

II. The corporate tax rate is increased.
III. The firm pays off its only outstanding debt.
IV. The Treasury Bond yield increases.

 A. I and III.
 B. III and IV.correct
 C. I, III and IV.
 D. II and IV.
Question was not answered
Correct Answer Explanation:
If the company pays off its only outstanding debt, its interest expense will go away
completely. Remember that the weighted average cost of capital is the weighted
average cost of all financing, debt and equity included. Debt generally has a lower cost
of capital than equity because of the effect of taxes, which reduce the effective interest
rate of debt. So if the debt goes away, all that will be left is equity, and equity has a
higher cost of capital than debt does. Therefore, the firm’s cost of capital as a rate will
increase.
An increase in the Treasury Bond yield will also cause the firm’s cost of capital to
increase. The yield on Treasury securities is determined by market supply and demand
for those securities. When the market rate for Treasury securities (considered the risk-
free rate) increases, usually corporate bond market rates also increase in order to
maintain the same risk premium as previously. When market rates increase, the market
price of existing securities decreases in order to cause their rates of return to match the
market rate of return. So corporate bonds’ market prices will decrease and their market
rates will increase.
Remember that cost of capital calculations are based on market prices of the stocks or
bonds, not the issuing company’s book value for the stocks or bonds. So when the
market prices of a firm’s outstanding securities decrease, the firm’s calculated cost of
capital for those securities will increase.
Explanation for Choice A:
Reducing its operating leverage would not cause the firm's cost of capital to increase.
Reducing its operating leverage would decrease the firm’s cost of capital, because it
would decrease the amount of risk that investors would perceive in the company.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice C:
Reducing its operating leverage would not cause the firm's cost of capital to increase.
Reducing its operating leverage would decrease the firm’s cost of capital, because it
would decrease the amount of risk that investors would perceive in the company.
Explanation for Choice D:
An increase in the corporate tax rate would not cause the firm's cost of capital to
increase. If the corporate tax rate increases, this will decrease the net amount of
interest expense (after taxes) that the firm has to pay on its debt, and that would also
decrease the firm’s cost of capital.
To understand why this is so, suppose a company has net income before interest and
taxes of $100,000. The tax rate is 40%. Interest expense is $10,000. So net income
after subtracting interest expense is $90,000. Income tax is 40% of that, or $36,000, so
net income after interest and taxes are deducted is $54,000. If the company had not
had the interest expense, its net income before tax would have been $100,000. Its tax
would have been $40,000, and its net income would have been $60,000. Therefore, the
company’s interest expense, net of taxes, is the difference between $60,000 net income
and $54,000 net income, which is only $6,000. That is less than the $10,000 that the
company actually paid in interest. The reason is because taxes on the company’s net
income reduced its effective interest rate.
Now, suppose the income tax rate increases to 45%. Net income after subtracting
interest expense is still $90,000. But now, income tax is 45% of that, or $40,500. Net
income after tax is now $49,500. Let’s compare that again with what the company’s net
income would have been without the interest expense. Net income would have been
$100,000, and income tax would have been $45,000. The company’s net income would
have been $55,000. So the company’s interest expense, net of taxes, is the difference
between $55,000 net income without interest expense and $49,500 net income with
interest expense, or $5,500. The net amount of interest expense, after taxes, for the
company is actually less ($5,500 versus $6,000) than it was when the tax rate was 40%.
173. Question ID: ICMA 19.P2.073 (Topic: Cost of Capital )
A public company’s shareholders expect to receive a dividend one year from now of $20
per share. Immediately after the dividend payout, analysts are expecting that the stock
will trade at $244 per share. If the investors have a required rate of return of 20%, what
is the current value of the stock?

 A. $244.
 B. $264.
 C. $220.correct
 D. $224.
Question was not answered
 Hock P2 2020
Section B - Corporate Finance.
Answers
Correct Answer Explanation:
Given the information that is in the question, the formula we will use to calculate the
value of the share today is:
P0 = (D1 + P1) / 1 + R
We are given all of the variables in the question. Putting them into this formula gives us:
P0 = ($20 + $244) / 1 + .20
Solving for P0 gives us $220.
Explanation for Choice A:
This is the expected value of the share after the dividend in one year. See the correct
answer for a complete explanation.
Explanation for Choice B:
This is the expected value of the share after the dividend in one year plus the value of
the dividend. See the correct answer for a complete explanation.
Explanation for Choice D:
This is the expected value of the share after the dividend in one year minus the amount
of the expected dividend. See the correct answer for a complete explanation.
174. Question ID: CMA 1294 1.26 (Topic: Cost of Capital )
DQZ Telecom is considering a project for the coming year that will cost $50 million.
DQZ plans to use the following combination of debt and equity to finance the
investment.

 Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8%, and
flotation costs of 2% of par.
 Use $35 million of funds generated from earnings.
 The equity market is expected to earn 12%. U.S. Treasury bonds are currently
yielding 5%. The beta coefficient for DQZ is estimated to be .60. DQZ is subject to
an effective corporate income tax rate of 40%.
Assume that the after-tax cost of debt is 7% and the cost of equity is 12%. Determine
the weighted-average cost of capital.

 A. 10.50%correct
 B. 8.50%
 C. 6.30%
 D. 9.50%
Question was not answered
 Hock P2 2020
Section B - Corporate Finance.
Answers
Correct Answer Explanation:
The 7% debt cost and the 12% equity cost should be weighted by the proportions of the
total investment represented by each source of capital. The weighting should be
calculated according to market value of each source. The market value of the bonds is
1.01 × $15,000,000, which is $15,150,000. Unless there is some reason to value it
differently, the market value of retained earnings is simply the amount of retained
earnings.
The total funding is $50,150,000 ($15,150,000 + $35,000,000), and debt is 30.21% of
that ($15,150,000 ÷ $50,150,000. Equity (or retained earnings) is 69.79% of the total
($35,000,000 ÷ $50,150,000).
Therefore, the WACC is:

Debt 0.3021 × 0.07 0.02115

Equity 0.6979 × 0.12 0.08375
Total WACC 0.10490 or 10.5% rounded
Explanation for Choice B:
The 7% debt cost and the 12% equity cost should be weighted by the proportions of the
total investment represented by each source of capital. An answer of 8.50% results from
reversing the weights.
Explanation for Choice C:
The cost of debt is 7% and the cost of equity is 12%. The weighted-average cost cannot
be less than all of its components.
Explanation for Choice D:
An answer of 9.50% assumes that debt and equity are equally weighted, i.e., it is an
unweighted average of the 7% cost of debt and the 12% cost of equity.
175. Question ID: CMA 1291 1.8 (Topic: Cost of Capital )
The firm's marginal cost of capital

 A. is inversely related to the firm's required rate of return used in capital budgeting.
 B. should be the same as the firm's rate of return on equity.
 C. is a weighted average of the investors' required returns on debt and equity.correct
 D. is unaffected by the firm's capital structure.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
The marginal cost of capital is the cost of obtaining the next dollar of financing. It is
approximately equal to the weighted average of the investors' required returns on debt
and equity.
Explanation for Choice A:
Any relationship between the company's marginal cost of capital and the required rate
of return used in a particular capital budgeting analysis is specific to that capital
budgeting analysis only. The required rate of return used in a particular capital
budgeting analysis can be any rate that management considers appropriate for the
specific capital budgeting project being analyzed. That may be the marginal cost of
capital, it may be the company's weighted average cost of capital, or it could be any rate
higher or lower than either of those rates. Higher or lower rates can be used to
incorporate into a capital budgeting analysis an allowance for a level of risk that is
judged to be higher or lower than the company's usual business risk.
Explanation for Choice B:
The marginal cost of capital should be less than the return on equity. If the capital costs
more than the return received, the company would not have an incentive to invest.
Explanation for Choice D:
The marginal cost of capital is greatly affected by the capital structure of the firm.
176. Question ID: CMA 1294 1.25 (Topic: Cost of Capital )
DQZ Telecom is considering a project for the coming year that will cost $50 million.
DQZ plans to use the following combination of debt and equity to finance the
investment.

 Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8%, and
flotation costs of 2% of par.
 Use $35 million of funds generated from earnings.
 The equity market is expected to earn 12%. U.S. Treasury bonds are currently
yielding 5%. The beta coefficient for DQZ is estimated to be 0.60. DQZ is subject to
an effective corporate income tax rate of 40%.
The before-tax cost of DQZ's planned debt financing, net of flotation costs, in the first
year is

 A. 11.80%
 B. 8.08%correct
 C. 10.00%
 D. 7.92%
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Proceeds are $14,850,000 [(1.01 x $15,000,000) − (0.02 x $15,000,000)]. Interest paid
during the first year will be $1.2 million (0.08 coupon rate x $15,000,000). Thus, the
company is paying $1.2 million for one year for the use of $14,850,000, a rate of 8.08%
($1,200,000 ÷ $14,850,000).
Note that this is not the effective interest rate for the life of the bond but only the cash
cost for the first year. In order to calculate the true effective interest rate of new debt
where there are flotation costs and a bond premium or discount, it is necessary to
incorporate the amortization of the premium/discount as well as the amortization of the
bond issue costs, because the face amount of the bond is what will be paid back at its
maturity. Since such an in-depth calculation would take too much time in a question like
this on an exam where time is limited, this question asks only for the cost of the debt
financing in the first year, not the effective annual interest rate.
Explanation for Choice A:
This answer could result from using the investors' expected return on the equity market
(0.12) and reducing it by 2% (flotation costs) of the 12%, or 0.0024. The expected return
on the equity market is not used to calculate the cost of debt.
Explanation for Choice C:
10.00% is the sum of the coupon rate and the flotation rate.
Explanation for Choice D:
7.92% ignores the 2% flotation costs.
177. Question ID: CMA 1295 1.16 (Topic: Cost of Capital )
A firm's target or optimal capital structure is consistent with which one of the following?

 A. Maximum earnings per share.

 B. Minimum risk.
 C. Minimum cost of debt.
 D. Minimum weighted average cost of capital.correct
Question was not answered
Correct Answer Explanation:
The optimal capital structure is the one that has the lowest (minimum) weighted average
cost of capital. This is the capital structure that most effectively and efficiently provides
the capital that the company needs.
Explanation for Choice A:
There is no relationship between the capital structure and earnings per share.
Explanation for Choice B:
 Hock P2 2020
Section B - Corporate Finance.
Answers
The capital structure that has the minimum risk may not be the most ideal capital
structure as the cost of the capital may be higher than in other options. See the correct
answer for a complete explanation.
Explanation for Choice C:
The ideal capital structure is the one that will minimize the total cost of capital, not just
the cost of debt.
178. Question ID: CMA 1288 1.4 (Topic: Cost of Capital )
Wiley's new financing will be in proportion to the market value of its present financing,
shown below.

Book Value
($000 Omitted)
Long-term debt $7,000
Preferred stock (100 shares) 1,000
Common stock (200 shares) 7,000
The firm's bonds are currently selling at 80% of par, generating a current market yield of
9%, and the corporation has a 40% tax rate. The preferred stock is selling at its par
value and pays a 6% dividend. The common stock has a current market value of $40
and is expected to pay a $1.20 per share dividend this fiscal year. Dividend growth is
expected to be 10% per year. Wiley's weighted average cost of capital is (round your
calculations to tenths of a percent).

 A. 11.0%.
 B. 9.0%.
 C. 9.6%.correct
 D. 10.8%.
Question was not answered
Correct Answer Explanation:
In order to calculate the WACC we need to determine the cost and fair value of each of
the components of the financing and the calculate their weighted average. In this
question, the components of financing are 1) debt, 2) preferred shares, and 3) common
shares.
The debt has a fair value of $5,600 (because it is selling at 80% of the book value) and
the interest cost is 9%. However, because the interest on the debt is tax-deductible, the
after-tax cost is 0.09 × (1 − 0.40), which is 0.054 or 5.4%.
The preferred shares have a market value of $1,000 and a cost of 6%. There is no
effect of taxes on the preferred dividends since dividends are not tax-deductible.
 Hock P2 2020
Section B - Corporate Finance.
Answers
The common stock has a market value of $8,000 (200 shares outstanding × $40 per
share). The cost of the common stock is determined using the Gordon Growth (or
Dividend Growth) model, and we get a cost of 13%: (1.20 ÷ 40) + 0.10 = 0.13 or 13%.
The total market value of the capital is $5,600 + $1,000 + $8,000 = $14,600. Debt is
38% of the total ($5,600 ÷ $14,600); preferred stock is 7% of the total ($1,000 ÷
$14,600); and equity is 55% of the total ($8,000 ÷ $14,600). The weighted average cost
of capital is the sum of the weight for each component multiplied by its cost, which is:
(0.38 × 0.054) + (0.07 × 0.06) + (0.55 × 0.13) = 0.0962 or 9.6%.
Explanation for Choice A:
This answer did not include the effect of taxes in the calculation of the cost of debt. See
the correct answer for a complete explanation.
Explanation for Choice B:
This answer results from using the book values of the components of capital instead of
their market values in calculating the weights for each component of the capital.
Explanation for Choice D:
This answer used the face value of the debt instead of the market value of the debt and
the before-tax cost of the debt instead of the after-tax cost of the debt in the calculation
of the cost of capital. See the correct answer for a complete explanation.
179. Question ID: CFM Sample Q. 7 (Topic: Cost of Capital )
Rogers Inc. operates a chain of restaurants located in the Southeast. The company has
steadily grown to its present size of 48 restaurants. The board of directors recently
approved a large-scale remodeling of the restaurant, and the company is now
considering two financing alternatives.
The first alternative would consist of

 Bonds that would have a 9% effective annual rate and would net $19.2 million after
flotation costs
 Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4%
flotation cost
 Common stock that would yield $24 million after a 5% flotation cost
The second alternative would consist of a public offering of bonds that would have an
11% effective annual rate and would net $48 million after flotation costs.
Rogers' current capital structure, which is considered optimal, consists of 40% long-term
debt, 10% preferred stock, and 50% common stock. The current market value of the
common stock is $30 per share, and the common stock dividend during the past 12
months was $3 per share. Investors are expecting the growth rate of dividends to equal
the historical rate of 6%. Rogers is subject to an effective income tax rate of 40%.
 Hock P2 2020
Section B - Corporate Finance.
Answers
The after-tax cost of the common stock proposed in Rogers' first financing alternative
would be

 A. 17.16%correct
 B. 16.00%
 C. 16.53%
 D. 16.60%
Question was not answered
Correct Answer Explanation:
To determine the cost of new common stock, the dividend growth model is adjusted to
include flotation cost as follows:

D1
C = +G
P0 × (1 − flotation cost)
Therefore,

$3.18
C = + 0.06 = 0.1716 or 17.16%
(30 × 0.95)
Explanation for Choice B:
This answer omits the increase in dividends and the flotation costs. The last dividend
was $3.00 per share, so the next dividend will be $3.00 × 1.06, since the dividend is
expected to increase by 6% per year.
Explanation for Choice C:
This answer results from failing to increase the dividend to the next dividend. The last
dividend was $3.00 per share, so the next dividend will be $3.00 × 1.06, since the
dividend is expected to increase by 6% per year.
Explanation for Choice D:
This answer omits the flotation costs from the calculation of the cost of the common
stock.
180. Question ID: CMA 1294 1.29 (Topic: Cost of Capital )
Which one of the following factors might cause a firm to increase the debt in its financial
structure?

 A. An increase in the Federal funds rate.

 B. An increase in the price-earnings (PE) ratio.
 C. An increase in the corporate income tax rate.correct
 D. Increased economic uncertainty.
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Section B - Corporate Finance.
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Question was not answered
Correct Answer Explanation:
Because the interest that is paid on debt is tax deductible, an increase in the tax rate
may cause a firm to increase the debt in its capital structure. It would do this because
the increased tax rate will decrease the after tax cost of debt to the company.
Explanation for Choice A:
An increase in the Federal Fund rate will decrease debt financing because the interest
that will need to be paid on the debt will be higher because of the higher Fed rate.
Explanation for Choice B:
If the PE ratio is increasing, that means that the company is becoming a more attractive
investment opportunity. Therefore, more people will want to buy the shares and the cost
of equity will decrease. This means that the company is more likely to issue equity as
the PE ratio increases.
Explanation for Choice D:
Increased uncertainty about the future would probably lead the company to issue more
equity. If the company issued more debt they will have more fixed interest costs in the
future which will increase the risks related to the uncertainty about the future.
181. Question ID: CMA 1288 1.2 H2 (Topic: Cost of Capital )
Which of the following is true regarding the calculation of a firm's cost of capital?

 A. The time value of money should be excluded from the calculations.

 B. The cost of capital is the cost of equity.
 C. All costs should be expressed as pre-tax costs.
 D. The cost of capital of a firm is the weighted-average cost of its various financing
components.correct
Question was not answered
Correct Answer Explanation:
The cost of capital is the weighted average cost of its various sources of financing.
Explanation for Choice A:
The time value of money is incorporated in the calculation of a firm's cost of capital.
Explanation for Choice B:
The cost of capital includes the cost of equity, but it is not equal to the cost of equity.
Explanation for Choice C:
 Hock P2 2020
Section B - Corporate Finance.
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Taxes are included in the calculation of a firm's cost of capital. For instance, the cost of
debt is affected by the fact that interest expense is a deductible expense. Therefore, all
costs should be expressed as after-tax costs.
182. Question ID: CMA 692 1.13 (Topic: Cost of Capital )
The theory underlying the cost of capital is primarily concerned with the cost of

 A. Short-term funds and new funds.

 B. Short-term funds and old funds.
 C. Long-term funds and old funds.
 D. Long-term funds and new funds.correct
Question was not answered
Correct Answer Explanation:
The theory underlying the cost of capital is based primarily on the cost of long-term
funds and the acquisition of new funds. The reason is that long-term funds are used to
finance long-term investments. For an investment alternative to be viable, the return on
the investment must be greater than the cost of the funds used. The objective in short-
term borrowing is different. Short-term loans are used to meet working capital needs
and not to finance long-term investments.
Explanation for Choice A:
Because the cost of short-term funds is not usually a concern for investment purposes.
Explanation for Choice B:
Because the cost of old funds is a sunk cost and of no relevance for decision-making
purposes. Similarly, short-term funds are used for working capital or other temporary
purposes, and there is less concern with the cost of capital and the way it compares
with the return earned on the assets borrowed.
Explanation for Choice C:
Because the concern is with the cost of new funds; the cost of old funds is a sunk cost
and of no relevance for decision-making purposes.
183. Question ID: CMA 1291 1.10 (Topic: Raising Capital)
A firm's dividend policy may treat dividends either as the residual part of a financing
decision or as an active policy strategy.
Treating dividends as the residual part of a financing decision assumes that

 A. Dividend payments should be consistent.

 B. Dividends are relevant to a financing decision.
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Section B - Corporate Finance.
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 C. Dividends are important to shareholders, any earnings left over after paying dividends
should be invested in high-return assets.
 D. Earnings should be retained and reinvested as long as profitable projects are
available.correct
Question was not answered
Correct Answer Explanation:
Under the residual dividend theory it is assumed that the profits of the company should
be distributed as dividends only if that is the best use of the money. If the company has
an investment opportunity that is better than what the shareholders are able to earn,
under a residual dividend policy, the money would be reinvested and not paid as
dividends. On the other hand, when there are no options that provide a higher return
than the shareholders earn, the company pays dividends and lets the shareholders
make the best investment available to them.
Explanation for Choice A:
Under the residual dividend policy, the amount distributed as dividends will not be
consistent over time. The amount distributed depends on the earnings of the company
and the investment opportunities that are available to the company.
Explanation for Choice B:
Under residual dividend theory, dividends are not relevant to a financing decision.
Explanation for Choice C:
Under the residual dividend policy it is the other way around. Only money that is left
over after all favorable investments are made is distributed as dividends.
184. Question ID: CMA 1291 1.11 (Topic: Raising Capital)
A firm's dividend policy may treat dividends either as the residual part of a financing
decision or as an active policy strategy.
Treating dividends as an active policy strategy assumes that

 A. Dividends are irrelevant.

 B. The firm should pay dividends only after investing in all investment opportunities having
an expected return greater than the cost of capital.
 C. Dividends provide information to the market.correct
 D. Dividends are costly, and the firm should retain earnings and issue stock dividends.
Question was not answered
Correct Answer Explanation:
If the dividend policy of a company is treated as an active policy strategy, this means
that the company believes that the payment (or nonpayment) of dividends provides
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Section B - Corporate Finance.
Answers
information about the company to the market. Therefore, the company will be very
careful and specific with the amount that they pay as dividends each period.
Explanation for Choice A:
Treating dividends as an active policy strategy indicates that dividends are not
perceived to be irrelevant.
Explanation for Choice B:
This is a description of the residual dividend policy. See the correct answer for a
complete explanation.
Explanation for Choice D:
An active dividend policy assumes that shareholders want dividends to be paid and
therefore profits of the company should not be withheld.
185. Question ID: ICMA 13.P2.033 (Topic: Raising Capital)
Monroe Company needs an additional machine that will be used for the next five years
at which time the machine will be obsolete and have zero salvage value. Monroe has
two options available: purchase the asset for the list price of $300,000 cash, or lease
the asset, requiring five annual lease payments of $68,000 with the first payment due
immediately. The lease payments include 6% interest. Excluding depreciation
considerations, the best alternative is to

 A. lease the asset for a $13,584 advantage.

 B. purchase the asset for a $3,620 advantage.correct
 C. lease the asset for a $45,918 advantage.
 D. purchase the asset for a $40,000 advantage.
Question was not answered
Correct Answer Explanation:
The purchase would take place for $300,000 cash at Year 0. The lease would require 5
payments of $68,000 each, with the first payment to be made immediately. Because the
first payment is to be made immediately, this is an annuity due, where the annuity
payments are made at the beginning of each period instead of at the end of the period.
To determine whether the lease or the purchase would be more advantageous, the
present value of the annuity payments discounted at 6% is compared with the cash
purchase price to find which present value is lower. The present value of the annuity
payments on the lease is equal to the principal amount of the lease, which is the
amount that would be paid for the machine under the lease.
The present value factor for an annuity due is the factor for one period less than the
number of periods, plus 1.000. The present value factor for 4 years (5 years minus 1) at
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6% is 3.465. 3.465 + 1.000 = 4.465, and that is the factor to use to calculate the present
value of the lease payments.
The present value of the lease payments is $68,000 × 4.465, which equals $303,620.
The cash purchase price of $300,000 is $3,620 less than the present value of the lease
payments. Thus Monroe Company should purchase the machine because the purchase
cost will be $3,620 less than the leasing cost.
Explanation for Choice A:
This is the difference between the $300,000 cash purchase price and the annual lease
payment of $68,000 multiplied by the present value of an annuity factor for 5 years at
6% (the factor rounded to 3 decimals).
Because the first lease payment is due immediately, the lease payments are to be
made at the beginning of each period, not at the end of each period. This is an annuity
due instead of an ordinary annuity. The present value factor for an annuity due is the
factor for one period less than the total number of periods, plus 1.000.
Explanation for Choice C:
This is the difference between the $300,000 cash purchase price and the present value
of the total of the five lease payments discounted using the present value of $1 factor
for 6% for 5 years (0.7473). The five lease payments constitute an annuity due, so
calculating their present value as the present value of one lump sum ($340,000) to be
paid at the end of five years is incorrect.
Explanation for Choice D:
This is the difference between $68,000 × 5, which is $340,000, and the $300,000
purchase price. The lease payments include interest at 6%, so the portion of each
payment that is interest should not be included in the net price for the machine under
the lease.
186. Question ID: CMA 693 4.21 (Topic: Raising Capital)
Essex Corporation is evaluating a lease that takes effect on March 1. The company
must make eight equal payments, with the first payment due on March 1. The concept
most relevant to the evaluation of the lease is

 A. The future value of an annuity due.

 B. The present value of an ordinary annuity.
 C. The future value of an ordinary annuity.
 D. The present value of an annuity due.correct
Question was not answered
Correct Answer Explanation:
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Section B - Corporate Finance.
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An annuity is a constant stream of cash either paid or received over a period of time and
at the same point in each period. The present value of an annuity is the value today of
payments to be received in the future.
If the cash is paid or received at the beginning of each period rather than at the end of
each period, the annuity is an "annuity due." Since the first payment is due as soon as
the lease takes effect, the lease payments constitute an annuity due.
Therefore, the present value of an annuity due would be the concept most relevant to
the evaluation of a lease with the first payment due on the same date the lease takes
effect.
Explanation for Choice A:
The future value of an annuity due would tell us how much some known amount of
money added to an accumulation at the beginning of each period would be worth in a
given number of periods. It is not used to evaluate a lease.
Explanation for Choice B:
An ordinary annuity assumes that payments are made or received at the end of each
period. Because the first payment is due as soon as the lease takes effect, the leease
payments do not constitute an ordinary annuity.
Explanation for Choice C:
The future value of an ordinary annuity would tell us how much some known amount of
money added to an accumulation at the end of each period would be worth in a given
number of periods. It would not be used to evaluate a lease.
187. Question ID: CIA 1191 IV.58 (Topic: Raising Capital)
A firm must select from among several methods of financing arrangements when
meeting its capital requirements. To acquire additional growth capital while attempting
to minimize its cost of capital, a firm should normally

 A. Discontinue dividends and use current cash flow, which avoids the cost and risk of
increased debt and the dilution of current common shareholders' ownership caused by
increased equity.
 B. Attempt to increase both debt and equity in equal proportions, which preserves a stable
capital structure and maintains investor confidence.
 C. Select equity over debt initially, which minimizes risk and avoids interest costs.
 D. Select debt over equity initially, even though increased debt is accompanied by interest
costs and a degree of risk.correct
Question was not answered
Correct Answer Explanation:
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Section B - Corporate Finance.
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The cost of capital will ordinarily be lower if debt is used to raise capital in preference to
equity, provided that the firm is not over-leveraged. The reason the cost of debt is lower
than the cost of equity is because interest is tax deductible, whereas dividends are not.
However, beyond a certain level of increased debt, investors will require a higher return
on their investments because of the increased risk of insolvency caused by the
increased debt. As a result, the cost of all forms of capital will increase.
Explanation for Choice A:
Using only current cash flow to raise capital is usually too conservative an approach for
a growth-oriented firm. Management is expected to be willing to take acceptable risks to
be competitive and attain an acceptable rate of growth. Furthermore, discontinuing
dividends would send a negative message to the market that would cause the market
value of the company's common stock to go down which would, in turn, cause its cost of
equity capital to increase.
Explanation for Choice B:
The cost of capital is not minimized by proportional increases in both debt and equity.
The cost of capital is usually lower, at least initially, if debt is used in preference to
equity to raise capital. Furthermore, equal proportions of new debt and equity would
probably not preserve a stable capital structure.
Explanation for Choice C:
Equity capital is initially more costly than debt, so a firm that is attempting to minimize its
cost of capital would not normally choose equity over debt.
188. Question ID: CMA 695 P2 Q17 (Topic: Raising Capital)
Corporations purchase their outstanding stock for all of the following reasons except to

 A. use the shares for a stock dividend.

 B. improve short-term cash flow.correct
 C. increase earnings per share by reducing the number of shares outstanding.
 D. meet employee stock compensation contracts.
Question was not answered
Correct Answer Explanation:
If a company buys its own shares that will require a cash outflow. This will therefore not
improve short-term cash flows.
Explanation for Choice A:
This is one of the reasons that a company may purchase its own shares.
Explanation for Choice C:
This is one of the reasons that a company may purchase its own shares.
 Hock P2 2020
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Explanation for Choice D:
This is one of the reasons that a company may purchase its own shares.
189. Question ID: ICMA 10.P2.187 (Topic: Raising Capital)
The residual theory of dividends argues that dividends

 A. are necessary to maintain the market price of the common stock.

 B. can be paid if there is income remaining after funding all attractive investment
opportunities.correct
 C. can be foregone unless there is an excess demand for cash dividends.
 D. are irrelevant.
Question was not answered
Correct Answer Explanation:
A residual dividend policy is one in which a dividend will be paid only if the funds are not
needed for investment. The company assumes that its shareholders want the company
to pay them a dividend only if the company is unable to reinvest its earnings at a higher
rate of return than the shareholder could. Thus, the company will distribute dividends
when there are no better alternatives for its money.
Explanation for Choice A:
This is not the residual theory of dividends. A residual dividend policy is one in which a
dividend will be paid only if the funds are not needed for investment.
Explanation for Choice C:
This is not the residual theory of dividends. A residual dividend policy is one in which a
dividend will be paid only if the funds are not needed for investment.
Explanation for Choice D:
This is not the residual theory of dividends. A residual dividend policy is one in which a
dividend will be paid only if the funds are not needed for investment.
190. Question ID: ICMA 10.P2.189 (Topic: Raising Capital)
When determining the amount of dividends to be declared, the most important factor to
consider is the

 A. future planned uses of retained earnings.

 B. future planned uses of cash.correct
 C. expectations of the shareholders.
 D. impact of inflation on replacement costs.
Question was not answered
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Correct Answer Explanation:
Dividends are paid from cash. They should be paid only if the cash is available without
putting the company in a situation where it may be short on cash.
Explanation for Choice A:
Cash dividends are not paid from retained earnings, even though they are accounted for
as a reduction in retained earnings. Thus, future planned uses of retained earnings is
not the most important factor to consider when determining the amount of dividends to
be declared. it is more important to consider whether cash will be available to pay the
dividends, since dividends are paid from cash.
Explanation for Choice C:
Shareholder expectations are not the most important factor to consider when
determining the amount of dividends to be declared. it is more important to consider
whether cash will be available to pay the dividends, since dividends are paid from cash.
Explanation for Choice D:
The impact of inflation on replacement costs is not the most important factor to consider
when determining the amount of dividends to be declared. it is more important to
consider whether cash will be available to pay the dividends, since dividends are paid
from cash.
191. Question ID: ICMA 10.P2.175 (Topic: Raising Capital)
Which of the following financing vehicles would a commercial bank be likely to offer to
its customers?

I. Discounted notes
II. Term loans
III. Lines of credit
IV. Self-liquidating loans

 A. I, II, III and IV.correct

 B. I and II.
 C. III and IV.
 D. I, III and IV.
Question was not answered
Correct Answer Explanation:
A commercial bank would offer all four of these financing vehicles.
 Hock P2 2020
Section B - Corporate Finance.
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Discounted notes are a method of calculating interest whereby the bank deducts
interest on a bank loan or note in advance. Discounted notes are generally secured.
A term loan is a loan that is repaid in regular payments over a period of several years. A
term loan may be secured or unsecured.
Lines of credit are short-term financing provided by a bank.

 A revolving line of credit is one that is contractually available to the borrower. It is

usually secured by a first lien on the borrower's receivables. The borrower's
customers send their payments directly to the bank, and the bank applies them to
the outstanding line of credit balance. Whenever the borrower needs funds, it
borrows against the line. The bank usually charges a commitment fee on the
unused portion of the loan.

 A line of credit is an amount of money that is available to a company at a bank.

This is essentially a preapproved loan that the company may access as it needs
the money. The line of credit is usually approved for one year at a time. Under this
arrangement, interest is not paid until the money is actually borrowed. An
unsecured line of credit is generally to be used only for short-term, seasonal needs;
thus there is usually a requirement that the line be "cleared," or paid down to zero,
for at least 30 days each year, in order to show the bank that the company is not
using the line for long-term financing needs. A line of credit such as this might be
unsecured, or it might be secured by a lien on the borrower's accounts receivable
and inventory. It is different from a revolving line of credit in that there is no
requirement for the borrower's customers to send their payments directly to the
bank for credit on the line. The borrower collects its own receivables and is
responsible for paying down or paying off the line balance when it has the cash to
do so.
A self-liquidating loan is a short-term working capital loan that is repaid from the
liquidation of the inventory and accounts receivable that the loan financed. A self-
liquidating loan is used to finance seasonal needs for cash to build up inventory ahead
of a busy season. When the inventory is sold and the accounts receivable from its sale
have been collected, the short-term loan can be paid off.
Explanation for Choice B:
Both of these financing vehicles would be likely to be offered by a commercial bank.
However, among those financing vehicles listed, these are not the only ones that would
be likely to be offered by a commercial bank.
Discounted notes are a method of calculating interest whereby the bank deducts
interest on a bank loan or note in advance. Discounted notes are generally secured.
A term loan is a loan that is repaid in regular payments over a period of several years. A
term loan may be secured or unsecured.
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Section B - Corporate Finance.
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Explanation for Choice C:
Both of these financing vehicles would be likely to be offered by a commercial bank.
However, among those financing vehicles listed, these are not the only ones that would
be likely to be offered by a commercial bank.
Lines of credit are short-term financing provided by a bank.

 A revolving line of credit is one that is contractually available to the borrower. It is

usually secured by a first lien on the borrower's receivables. The borrower's
customers send their payments directly to the bank, and the bank applies them to
the outstanding line of credit balance. Whenever the borrower needs funds, it
borrows against the line. The bank usually charges a commitment fee on the
unused portion of the loan.

 A line of credit is an amount of money that is available to a company at a bank.

This is essentially a preapproved loan that the company may access as it needs
the money. The line of credit is usually approved for one year at a time. Under this
arrangement, interest is not paid until the money is actually borrowed. An
unsecured line of credit is generally to be used only for short-term, seasonal needs;
thus there is usually a requirement that the line be "cleared," or paid down to zero,
for at least 30 days each year, in order to show the bank that the company is not
using the line for long-term financing needs. A line of credit such as this might be
unsecured, or it might be secured by a lien on the borrower's accounts receivable
and inventory. It is different from a revolving line of credit in that there is no
requirement for the borrower's customers to send their payments directly to the
bank for credit on the line. The borrower collects its own receivables and is
responsible for paying down or paying off the line balance when it has the cash to
do so.
A self-liquidating loan is a short-term working capital loan that is repaid from the
liquidation of inventory. It is used to finance seasonal needs for cash to build up
inventory ahead of a busy season. When the inventory is sold, the short-term loan can
be paid off.
Explanation for Choice D:
All three of these financing vehicles would be likely to be offered by a commercial bank.
However, among those financing vehicles listed, these are not the only ones that would
be likely to be offered by a commercial bank.
Discounted notes are a method of calculating interest whereby the bank deducts
interest on a bank loan or note in advance. Discounted notes are generally secured.
Lines of credit are short-term financing provided by a bank.
 Hock P2 2020
Section B - Corporate Finance.
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 A revolving line of credit is one that is contractually available to the borrower. It is
usually secured by a first lien on the borrower's receivables. The borrower's
customers send their payments directly to the bank, and the bank applies them to
the outstanding line of credit balance. Whenever the borrower needs funds, it
borrows against the line. The bank usually charges a commitment fee on the
unused portion of the loan.

 A line of credit is an amount of money that is available to a company at a bank.

This is essentially a preapproved loan that the company may access as it needs
the money. The line of credit is usually approved for one year at a time. Under this
arrangement, interest is not paid until the money is actually borrowed. An
unsecured line of credit is generally to be used only for short-term, seasonal needs;
thus there is usually a requirement that the line be "cleared," or paid down to zero,
for at least 30 days each year, in order to show the bank that the company is not
using the line for long-term financing needs. A line of credit such as this might be
unsecured, or it might be secured by a lien on the borrower's accounts receivable
and inventory. It is different from a revolving line of credit in that there is no
requirement for the borrower's customers to send their payments directly to the
bank for credit on the line. The borrower collects its own receivables and is
responsible for paying down or paying off the line balance when it has the cash to
do so.
A self-liquidating loan is a short-term working capital loan that is repaid from the
liquidation of inventory. It is used to finance seasonal needs for cash to build up
inventory ahead of a busy season. When the inventory is sold, the short-term loan can
be paid off.
192. Question ID: CMA 695 P1 Q11 (Topic: Raising Capital)
Brady Corporation has 6,000 shares of 5% cumulative, $100 par value preferred stock
outstanding and 200,000 shares of common stock outstanding. Brady's board of
directors last declared dividends for the year ended May 31, 20X0, and there were no
dividends in arrears at that time. For the year ended May 31, 20X2, Brady had net
income of $1,750,000. The board of directors is declaring a dividend for common
shareholders equivalent to 20% of net income. The total amount of dividends to be paid
by Brady at May 31, 20X2 is:

 A. $206,000
 B. $350,000
 C. $410,000correct
 D. $380,000
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
There are two dividends that Brady must pay. Before paying the common dividend, all
cumulative dividends that have been earned this period or are in arrears need to be
paid. A total of $600,000 par value of preferred, cumulative shares are outstanding that
earn a 5% dividend. The last dividend was declared for the year ended May 31, 20X0.
Therefore, the company needs to pay two years worth of preferred, cumulative
dividends before it can pay a common dividend. At 5%, the dividend is $30,000 per
year, for a total of $60,000 for the two years that needs to be paid. The second dividend
is the common dividend. It is 20% of net income. Net income was $1,750,000 and 20%
of this is $350,000. Adding together the two dividends, we get a total dividend to be paid
of $410,000.
Explanation for Choice A:
206,000 is the total number of common and preferred shares outstanding. It is not the
total dividends to be paid.
Explanation for Choice B:
This is the amount of the common dividend only. The preferred dividend also needs to
be paid.
Explanation for Choice D:
This includes only one year of the preferred cumulative dividend. However, since the
company has not paid the preferred, cumulative dividend for two years, two years of the
preferred dividend needs to be paid.
193. Question ID: CIA 590 IV.48 (Topic: Raising Capital)
The date when the right to a dividend expires is called the

 A. Ex-dividend date.correct
 B. Closing date.
 C. Holder-of-record date.
 D. Payment date.
Question was not answered
Correct Answer Explanation:
By definition, the ex-dividend date is the date when the right to a dividend expires. Any
investor who buys the stock on or after the ex-dividend date will not receive the next
dividend to be paid.
Explanation for Choice B:
There is no such thing as a "closing date" related to when the right to a dividend
expires.
Explanation for Choice C:
 Hock P2 2020
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The holder of record date is the date on which it is determined who will receive the
dividend.
Explanation for Choice D:
The payment date is the date on which the dividend will be paid.
194. Question ID: CMA 693 1.16 (Topic: Raising Capital)
Junk bonds are

 A. securities rated at less than investment grade.correct

 B. securities that are highly risky but offer only low yields.
 C. worthless securities.
 D. considered illegal.
Question was not answered
Correct Answer Explanation:
Securities that are rated at below investment grade are called junk bonds.
Explanation for Choice B:
Because of the high risk of junk bonds, they also return a very high rate of interest to
balance this increased risk.
Explanation for Choice C:
Junk bonds are not worthless. Rather, they are very risky bonds because there is a
much greater chance of default by the issuer, but the interest rate that they pay is much
higher because of this increased risk.
Explanation for Choice D:
The use of junk bonds is not illegal.
195. Question ID: ICMA 19.P2.077 (Topic: Raising Capital)
An agreement in which the underwriter attempts to sell as much as possible of an initial
public offering, but does not guarantee the sale of the entire offering is a

 A. carve-out deal.
 B. best-efforts deal.correct
 C. firm commitment deal.
 D. syndicate deal.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
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In a best-efforts deal, the underwriter agrees to attempt to sell as much of the offering
as possible, but they make no guarantee about how much will be able to be sold.
Explanation for Choice A:
An equity carve-out involves the sale to the public of a part of the company in an initial
public offering. An equity carve-out is a form of equity financing.
Explanation for Choice C:
In a firm commitment deal, the investment bank assumes all the risks associated with
the issue and receives a sizable fee for assuming that risk.
Explanation for Choice D:
In a syndicate deal, the original investment bank invites others to subscribe to a portion
of the issue, in exchange for which the others will receive a portion of the fees.
196. Question ID: CMA 1288 1.6 (Topic: Raising Capital)
The best reason for financial managers to use shelf registration for debt or equity
offerings is because:

 A. Corporations do not have to register new securities with the Securities and Exchange
Commission.
 B. Issuers are spared the expense of filing several registrations by registering offerings in
advance and then issuing them quickly under favorable market conditions.correct
 C. This technique provides businesses more flexibility in selection of an investment
banker.
 D. Smaller, regional underwriters are used more frequently to distribute the new issues,
saving firms issuance costs.
Question was not answered
Correct Answer Explanation:
A shelf registration enables a company to register shares but then not immediately
issue them. A company that qualifies for a shelf registration is able to make one large
registration and then sell the shares as they are needed instead of making many
smaller registrations as there is a need to sell the shares.
Explanation for Choice A:
Shares registered under a shelf registration must still be registered with the SEC.
Explanation for Choice C:
The use of a shelf registration does not impact the decision about the investment
banker that will be used in the issuance.
Explanation for Choice D:
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Section B - Corporate Finance.
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Whether a shelf registration is used or not does not impact the size of the underwriter
used to distribute the issuance. That is determined by the size and scope of the
issuance.
197. Question ID: CIA 1190 IV.52 (Topic: Raising Capital)
An issue of securities for which the investment bank handling the transaction gives no
guarantee that the securities will be sold is a(n)

 A. Competitive bid issue.

 B. Best efforts issue.correct
 C. Negotiated issue.
 D. Underwritten issue.
Question was not answered
Correct Answer Explanation:
Only in a best efforts bid does the bank give no guarantee that the securities will be
sold. In a best efforts issue the bank agrees to sell as many of the securities as it can,
but any unsold securities are returned to the issuer.
Explanation for Choice A:
In a competitive bid issue the investment banks bid to buy the securities and they will
then resell them. But, no matter the amount that are resold, the issuer has sold the
securities.
Explanation for Choice C:
In a negotiated issue the investment bank buys the securities and they will then resell
them. But, no matter the amount that are resold, the issuer has sold the securities.
Explanation for Choice D:
In an underwritten issue the investment bank buys the securities and they will then
resell them. But, no matter the amount that are resold, the issuer has sold the
securities.
198. Question ID: ICMA 10.P2.190 (Topic: Raising Capital)
Underhall Inc.’s common stock is currently selling for $108 per share. Underhall is
planning a new stock issue in the near future and would like to stimulate interest in the
company. The Board, however, does not want to distribute capital at this
time. Therefore, Underhall is considering whether to offer a 2-for-1 common stock split
or a 100% stock dividend on its common stock. The best reason for opting for the stock
split is that

 A. it will not impair the company's ability to pay dividends in the future.correct
 B. it will not decrease shareholders' equity.
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Section B - Corporate Finance.
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 C. the par value per share will remain unchanged.
 D. the impact on earnings per share will not be as great.
Question was not answered
Correct Answer Explanation:
In order to answer this question correctly, it is necessary to know the difference
between the way a stock split and a stock dividend are accounted for. The payment of a
stock dividend is accounted for by reducing retained earnings by a portion of the stock
dividend’s value and increasing common stock (or common stock and additional paid-in
capital), whereas no journal entries at all are made for a stock split. Thus, a stock
dividend would reduce retained earnings – though it would not reduce not total equity –
while a stock split would not.
Cash dividends are also accounted for by reducing retained earnings. A cash dividend
cannot be paid if there is an insufficient balance in the retained earnings account.
Therefore, payment of a stock dividend could limit the company’s ability to pay future
cash dividends, whereas a stock split would not.
Explanation for Choice B:
Neither a stock dividend nor a stock split will decrease shareholders' equity. The
payment of a stock dividend is accounted for by reducing retained earnings by a portion
of the stock dividend’s value and increasing common stock (or common stock and
additional paid-in capital), whereas no journal entries at all are made for a stock split.
But neither a stock split nor a stock dividend decreases total shareholders' equity.
Explanation for Choice C:
In a stock split, the par value of the stock is reduced in the same ratio as the stock split.
For example, if the stock is split 2 for 1, after the split twice as many shares will be
outstanding and the par value of each share will be 1/2 what it was before the split.
(From an accounting standpoint, no entry is recorded for a stock split. A memorandum
note, however, is made to indicate that the par value of the shares has changed and the
number of shares has increased.)
Explanation for Choice D:
Basic earnings per share is income available to common shareholders divided by the
weighted average number of common shares outstanding. Earnings per share will be
the same whether Underhall offers a 2-for-1 common stock split or a 100% stock
dividend on its common stock, because the weighted average number of common
shares outstanding used for the EPS calculation will be the same.
199. Question ID: ICMA 13.P2.031 (Topic: Raising Capital)
Topka Inc. needs to borrow $500,000 to meet its working capital requirements for next
year. The Merchant Bank has offered the company a 9.5% simple interest loan that has
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a 16% compensating balance requirement. Determine the effective interest rate for the
loan.

 A. 12.75%.
 B. 11.02%.
 C. 19.00%.
 D. 11.31%correct
Question was not answered
Correct Answer Explanation:
When there is a compensating balance and no interest is earned on the compensating
balance, the effective interest rate is calculated by dividing the interest charge on the
entire amount of the loan by the new funds received after subtracting the compensating
balance. In this case, this is [($500,000 × 0.095) ÷ ($500,000 × 0.84)], or $47,500 ÷
$420,000, which is equal to 11.31%.
If the company needs a net amount of $500,000 for its working capital, it will actually
need to borrow more than $500,000, since the full amount of the loan will not be
available to use. The amount borrowed will need to be $500,000 ÷ (1 − 0.16), or
$595,238. Interest on $595,238 at 9.5% for one year will be $56,548. $56,548 ÷
$500,000 is also equal to 11.31%.
So either calculation will result in the correct answer.
Explanation for Choice A:
This is the average of the 9.5% simple interest and the 16% compensating balance
requirement. When there is a compensating balance and no interest is earned on the
compensating balance, the effective interest rate is calculated by dividing the interest
charge on the entire amount of the loan by the new funds received after subtracting the
compensating balance.
Explanation for Choice B:
This answer results from adding the compensating balance to the loan balance and
multiplying the result by the simple interest rate to find the amount of interest charged,
then dividing the amount of interest charged by the loan balance.
The compensating balance will come out of the loan amount, so it needs to be
subtracted from it, not added to it. And the amount of interest charged should be
calculated on the loan balance of $500,000, not on the loan balance plus the
compensating balance.
Explanation for Choice C:
This is the 9.5% simple interest rate multiplied by 2. When there is a compensating
balance and no interest is earned on the compensating balance, the effective interest
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rate is calculated by dividing the interest charge on the entire amount of the loan by the
new funds received after subtracting the compensating balance.
200. Question ID: ICMA 1603.P2.021 (Topic: Raising Capital)
The treasurer of a company plans to raise $500 million to finance its new business
expansion into the Asia Pacific region. The treasurer is analyzing initial public offerings.
All of the following are correct except that

 A. it is necessary for the company to file a registration statement with the SEC if it decides
to launch an initial public offering.
 B. one of the advantages of an initial public offering is that stock price can accurately
reflect the true net worth of the company after it goes public.correct
 C. an initial public offering will increase the liquidity of the company's stock and establish
the company's value in the market.
 D. under an underwritten offering, the investment bank will guarantee the sale of stock at
an offering price, however, the commission charged to the company will be higher
compared to a best efforts offering.
Question was not answered
Correct Answer Explanation:
The first time a company registers and sells shares of its stock to the investing public,
the offering is called an Initial Public Offering (IPO).
When securities are offered in an initial public offering, there is no current market price
to use as a benchmark. Initial public offering shares are usually offered only to large
institutional investors such as top pension funds, mutual funds, hedge funds, high net
worth individual investors, and long-standing clients of the investment bank handling the
offering. The initial offering price is generally based on what these institutional investors
are willing to pay per share, not on the true net worth of the company.
Explanation for Choice A:
This is a true statement. Prior to making a public offering, the company must register
the securities to be sold with the SEC. This registration involves disclosing important
information about the company, its business, and its finances so investors have the
necessary information to make an intelligent investment decision.
Explanation for Choice C:
This is a true statement. The first time a company registers and sells shares of its stock
to the investing public, the offering is called an Initial Public Offering (IPO). A company
can have only one IPO in its corporate history. Prior to the IPO, however, shares of
common stock have probably been sold or distributed to the founders and key
employees of the business and early stage investors called venture capitalists. These
shares are not, however, actively traded in a public market until the IPO takes place.
Therefore, the initial public offering will increase the liquidity of the company's stock.
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When securities are offered in an initial public offering, there is no current market price
to use as a benchmark. Initial public offering shares are usually offered only to large
institutional investors such as top pension funds, mutual funds, hedge funds, high net
worth individual investors, and long-standing clients of the investment bank handling the
offering. The initial offering price is generally based on what these institutional investors
are willing to pay per share.
After the initial sale, the stock begins trading on the secondary market and its value
becomes established by its market price in the secondary market, so the initial public
offering establishes the company's value in the market.
Explanation for Choice D:
This is a true statement. When the investment bank underwrites the offering, the
investment bank purchases the stock from the issuing company at an agreed-upon
offering price. Thus the company is guaranteed that all of its stock will be sold and at
what price it will be sold. The investment bank is then responsible for re-selling the
stock to the public at whatever price it can get for it. When the investment bank
assumes all the risks associated with the issue in this manner the investment bank
receives a sizable fee for assuming the risk.
If the investment bank believes there is too much risk that the entire offering may not be
marketable at the desired price, the investment bank may choose to act only as an
agent and market the shares under the best efforts form of distribution. The lead
manager agrees to sell as many shares as possible, but it does not guarantee any sale
price to the company and it does not purchase the shares itself for resale. The
investment bank is paid only for what it has sold, and the company is ultimately
responsible for the distribution of any unsold shares. The underwriter’s fee is lower for a
best efforts underwriting, since the investment bank is not taking on the risk of being
unable to sell a part of the offering or of being unable to sell the offering profitably.
201. Question ID: CMA 693 1.4 (Topic: Raising Capital)
In capital markets, the primary market is concerned with the provision of new funds for
capital investments through

 A. Exchanges of existing bond and stock securities.

 B. New issues of bond and stock securities and exchanges of existing bond and stock
securities.
 C. New issues of bond and stock securities.correct
 D. The sale of forward or future commodities contracts.
Question was not answered
Correct Answer Explanation:
By definition, the primary market is the market through which new issuances of bonds
and stock securities are issued.
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Section B - Corporate Finance.
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Explanation for Choice A:
Existing bonds and stock securities are exchanged through the secondary market.
Explanation for Choice B:
While the issuances of new stocks and bonds take place on the primary market, the
exchange of existing stocks and bonds takes place on the secondary market.
Explanation for Choice D:
Forward commodities contracts are sold in the secondary over-the-counter markets,
and future commodities contracts are sold on the secondary futures exchanges.
202. Question ID: CMA 689 1.9 (Topic: Raising Capital)
A sound justification for a firm's repurchase of its own stock, such as treasury stock, is
to

 A. increase the firm's total assets.

 B. lower the debt to equity ratio of the firm.
 C. meet the stock needs of a potential merger.correct
 D. reduce the idle cash and increase marketable securities.
Question was not answered
Correct Answer Explanation:
One of the reasons that a company may purchase treasury shares is to acquire enough
shares so that they can effect a potential merger.
Explanation for Choice A:
In order to purchase treasury stock the company must spend cash, which reduces the
assets of the company.
Explanation for Choice B:
By repurchasing shares the company would increase the debt-to-equity ratio.
Explanation for Choice D:
While the purchase of the treasury shares would reduce cash, it does not increase
marketable securities because treasury shares are not classified as marketable
securities.
203. Question ID: CMA 693 1.15 (Topic: Raising Capital)
The characteristics of venture capital include all of the following except

 A. Initial private placement for the majority of issues.

 B. A lack of liquidity for a period of time.
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Section B - Corporate Finance.
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 C. The use of common stock for most placements.
 D. A minimum holding period of 5 years for new securities.correct
Question was not answered
Correct Answer Explanation:
Venture capitalists do not have a minimum holding period because they will be looking
to sell their interest in the investment at a profit as soon as possible, even if it is less
than 5 years after the investment is made.
Explanation for Choice A:
Venture capital placements are usually private placements, so this answer is incorrect
since we need to find the choice that is not a characteristic of venture capital.
Explanation for Choice B:
Venture capital placements usually include a period of no liquidity after the investment is
made, so this answer is incorrect since we need to find the choice that is not a
characteristic of venture capital.
Explanation for Choice C:
Venture capital placements usually use common shares, so this answer is incorrect
since we need to find the choice that is not a characteristic of venture capital.
204. Question ID: ICMA 10.P2.191 (Topic: Raising Capital)
Kalamazoo Inc. has issued 25,000 shares of its authorized 50,000 shares of common
stock. There are 5,000 shares of common stock that have been repurchased and are
classified as treasury stock. Kalamazoo has 10,000 shares of preferred stock. If a $0.60
per share dividend has been authorized on its common stock, what will be the total
common stock dividend payment?

 A. $21,000
 B. $15,000
 C. $30,000
 D. $12,000correct
Question was not answered
Correct Answer Explanation:
25,000 common shares were issued, but because 5,000 shares have been repurchased
as treasury stock, only 20,000 shares remain outstanding. Dividends of $0.60 are paid
on each of those 20,000 shares of common stock for a total of $12,000.
Explanation for Choice A:
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Section B - Corporate Finance.
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This answer results from calculating the dividend on all issued shares of common stock
(25,000) plus all issued shares of preferred stock (10,000). The dividend was declared
only on the common stock.
Explanation for Choice B:
This includes a dividend paid on the shares classified as treasury stock. Dividends are
not paid on the 5,000 shares of treasury stock. Of the 25,000 common shares issued,
only 20,000 remain outstanding.
Explanation for Choice C:
This answer results from calculating the dividend on all authorized shares of common
stock (50,000). Dividends are paid only on shares that are issued and outstanding.
205. Question ID: ICMA 13.P2.020 (Topic: Raising Capital)
OldTime Inc. is a mature firm operating in a very stable market. Earnings growth has
averaged about 3.2% for the last dozen years, just staying in line with inflation. The
firm’s weighted average cost of capital is 8%, much lower than most firms'. John Storms
has just been hired as OldTime’s new CEO and wants to turn what he calls a “cash
cow” into a “growth company.” Storms wants to reduce the dividend pay-out and use the
resulting retained earnings to fund the firm’s expansion into new product lines.
OldTime’s historical beta has been about 0.6. With the CEO’s changes, what will most
likely happen to OldTime’s beta and the required return on investment in its shares?

 A. The beta will fall and the required return will fall.
 B. The beta will fall and the required return will rise.
 C. The beta will rise and the required return will rise.correct
 D. The beta will rise and the required return will fall.
Question was not answered
Correct Answer Explanation:
Because of the more aggressive growth strategy of the CEO, the company’s profits
going forward will fluctuate more than they have fluctuated in the past. The profits will
also most likely be more connected to the larger economy. These will cause the stock's
beta to rise. Because of more risk being taken on by the company in this strategy, the
investors' required rate of return will also rise.
Explanation for Choice A:
Because of the more aggressive growth strategy of the CEO, the company’s profits
going forward will fluctuate more than they have fluctuated in the past. The profits will
also most likely be more connected to the larger economy. These will cause the stock's
beta to rise. Because of more risk being taken on by the company in this strategy, the
required rate of return will also rise.
Explanation for Choice B:
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Section B - Corporate Finance.
Answers
Because of the more aggressive growth strategy of the CEO, the company’s profits
going forward will fluctuate more than they have fluctuated in the past. The profits will
also most likely be more connected to the larger economy. These will cause the stock's
beta to rise.
Explanation for Choice D:
Because of more risk being taken on by the company in this strategy, the investors'
required rate of return will rise.
206. Question ID: CIA 593 P4 Q46 (Topic: Raising Capital)
The policy decision that by itself is least likely to affect the value of the firm is the

 A. Distribution of stock dividends to shareholders.correct

 B. Investment in a project with a large net present value.
 C. Sale of a risky division that will now increase the credit rating of the entire company.
 D. Use of a more highly leveraged capital structure that resulted in a lower cost of capital.
Question was not answered
Correct Answer Explanation:
A stock dividend should not affect the value of the company. The distribution of a stock
dividend does not increase or decrease equity and will not generate a profit or cause a
loss.
Explanation for Choice B:
If the company enters into a project that has a large net present value, this should
increase the value of the company.
Explanation for Choice C:
If the company sells a risky division and improves its credit rating, this should increase
the value of the company.
Explanation for Choice D:
A structure that results in a lower cost of capital should increase the value of a firm.
207. Question ID: CMA 1296 1.9 (Topic: Raising Capital)
A 10% stock dividend most likely

 A. increases the size of the firm.

 B. increases shareholders' wealth.
 C. decreases net income.
 D. decreases future earnings per share.correct
Question was not answered
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Section B - Corporate Finance.
Answers
Correct Answer Explanation:
A stock dividend will increase the number of shares outstanding and this in turn will
most likely decrease earnings per share in the future since the profits of the company
will need to be divided among more shares.
Explanation for Choice A:
A stock dividend does not affect the size of the company.
Explanation for Choice B:
A stock dividend does not affect the shareholders' wealth since there is no distribution of
assets of the company and each individual shareholder's market value of their
investment remains unchanged after the stock dividend.
Explanation for Choice C:
A stock dividend does not impact the income of the company. It is accounted for entirely
within the owners' equity section of the balance sheet.
208. Question ID: CMA 689 P1 Q7 (Topic: Raising Capital)
A stock dividend

 A. decreases the size of the firm.

 B. increases shareholders' wealth.
 C. increases the debt-to-equity ratio of a firm.
 D. decreases future earnings per share.correct
Question was not answered
Correct Answer Explanation:
In a stock dividend more shares are issued to existing shareholders. Since there is no
increase in income from this event but there are more shares outstanding, future
earnings per share will decrease as a result of the stock dividend.
Explanation for Choice A:
A stock dividend does not impact the size of the firm.
Explanation for Choice B:
A stock dividend does not in itself increase shareholder wealth. The stock dividend
provides more shares to each shareholder, but since the value of each share
decreases, the total value of the shares remains unchanged.
Explanation for Choice C:
A stock dividend has no impact on the company's liabilities or on the book value of the
company's total equity. Therefore, there is no effect on the firm's debt-to-equity ratio.
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Section B - Corporate Finance.
Answers
209. Question ID: ICMA 10.P2.188 (Topic: Raising Capital)
Mason Inc. is considering four alternative opportunities. Required investment outlays
and expected rates of return for these investments are given below.

Project Investment Cost Rate of Return

A $200,000 12.5%
B $350,000 14.2%
C $570,000 16.5%
D $390,000 10.6%
The investments will be financed through 40% debt and 60% common equity. Internally
generated funds totaling $1,000,000 are available for reinvestment. If the cost of capital
is 11%, and Mason strictly follows the residual dividend policy, how much in dividends
would the company likely pay?

 A. $120,000
 B. $650,000
 C. $328,000correct
 D. $430,000
Question was not answered
Correct Answer Explanation:
Companies following the residual dividend policy use internally generated equity to
finance new projects. They pay dividends only out of what is left after all capital
requirements have been met, so they declare dividends only if there is enough money
left over after all operating and expansion needs are met.
If Mason maintains the 40% debt / 60% equity financing, then 60% of the chosen
investments will need to be financed from the $1,000,000 available funds. The
investments chosen should provide a rate of return greater than the cost of capital of
11%. The chosen investments should be A, B, and C. The total investment in these
projects is $1,120,000. Multiply that by the portion to be financed through the funds
available (60%) and you have $672,000. The remaining funds will be available for
dividends: $1,000,000 − $672,000 = $328,000.
Explanation for Choice A:
Companies following the residual dividend policy use internally generated equity to
finance new projects. They pay dividends only out of what is left after all capital
requirements have been met, so they declare dividends only if there is enough money
left over after all operating and expansion expenses are met.
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Section B - Corporate Finance.
Answers
This answer is the difference between the investments generating more than the cost of
capital and the funds available. ($200,000 + $350,000 + $570,000 − $1,000,000). In this
calculation, not only would there be no funds available for dividends, they are actually
$120,000 short of the money needed for the total investment.
Explanation for Choice B:
Companies following the residual dividend policy use internally generated equity to
finance new projects. They pay dividends only out of what is left after all capital
requirements have been met, so they declare dividends only if there is enough money
left over after all operating and expansion expenses are met.
This is the difference between the funds available and the cost of project B. See correct
answer for detailed calculations.
Explanation for Choice D:
Companies following the residual dividend policy use internally generated equity to
finance new projects. They pay dividends only out of what is left after all capital
requirements have been met, so they declare dividends only if there is enough money
left over after all operating and expansion expenses are met.
This is the difference between the funds available and the cost of project C. See correct
answer for detailed calculations.
210. Question ID: CMA 693 1.6 (Topic: Raising Capital)
Shelf registration of a security is a procedure allowing a firm to

 A. Register a security for a specified period of time and then sell the securities on a
piecemeal basis.correct
 B. Freeze the market price of its new issues of securities for a specified period of time.
 C. Register an issue price on its securities for a specified period of time.
 D. Control both the issue price and the secondary market price of its securities by
registering these prices for a specified period of time.
Question was not answered
Correct Answer Explanation:
In a shelf registration the company registers a large number of shares at one time and
then issues the shares as they are needed. This enables the company to make one
registration and then sell small blocks of those shares over time rather than having to
make a lot of different smaller registrations as they are needed.
Explanation for Choice B:
The issuer is not able to freeze (determine) the market price of securities for any period
of time.
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Section B - Corporate Finance.
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Explanation for Choice C:
The prices of securities are not registered.
Explanation for Choice D:
The prices of securities are not registered and the issuer is not able to control the price
on either the primary market or the secondary market.
211. Question ID: ICMA 08.P3.203 (Topic: Raising Capital)
Bell Delivery Co. is financing a new truck with a loan of $30,000, to be repaid in five
annual installments of $7,900 at the end of each year. What is the approximate annual
interest rate Bell is paying?

 A. 10%correct
 B. 16%
 C. 4%
 D. 5%
Question was not answered
Correct Answer Explanation:
An annual payment on a loan is an annuity. The principal balance of the loan is the
present value of the annuity.
The present value of an annuity is the annual amount paid or received at the end of
each year multiplied by a present value of annuity factor. Here, we have the present
value of the annuity ($30,000) and we have the annuity amount ($7,900). So we need to
find the factor. After we find the factor, we can look up the factor in a PV of an Annuity
table, and that will tell us the interest rate used to discount this annuity. That will be the
interest rate on the loan.
To find the factor, we divide $30,000 by $7,900, and the answer is 3.7975. We then go
to the PV of an Annuity table and look across from 5 years to find the factor that is
closest to 3.7975. The factor for 10% is 3.791, which is very close to 3.7975. Therefore,
the interest rate on this loan is approximately 10%.
Explanation for Choice B:
This would be the interest rate if the payments were due at the beginning of each year
(an annuity due). However, the payments are due at the end of each year.
Explanation for Choice C:
This is not the correct answer. Please see correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
 Hock P2 2020
Section B - Corporate Finance.
Answers
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice D:
This answer could result from dividing the annual payment by the principal balance of
the loan and dividing the result by 5, then rounding down to the nearest whole
percentage point.
The correct way to approach this is to treat the annual payment as an annuity and the
principal balance of the loan as the present value of the annuity. Since an annuity
amount multiplied by the appropriate discount factor equals the present value of the
annuity, the factor for the present value of this 5-year annuity will be the principal
balance of the loan divided by the annuity amount. After calculating the factor, go to the
PV of an Annuity table, look across the 5-year row and find the factor that is closest to
the calculated factor. Look up to the top of the column to find the interest rate.
212. Question ID: CMA 685 1.1 (Topic: Raising Capital)
A company can finance an equipment purchase through a loan. Alternatively, it often
can obtain the same equipment through a lease arrangement. A factor that
would not be considered when comparing the lease financing with the loan financing is:

 A. Whether the lessor has a higher cost of capital than the lessee.
 B. Whether the lessor and lessee have different tax reduction opportunities.
 C. The capacity of the equipment.correct
 D. Whether the property category has a history of rapid obsolescence.
Question was not answered
Correct Answer Explanation:
The capacity of the equipment is considered in the decision to buy or not buy the
equipment. Once the decision has been made, the capacity is not relevant in the
decision as to whether to purchase the equipment with a loan or whether to lease the
equipment.
Explanation for Choice A:
The interest rates of the lessee and the lessor will determine whether or not the rate
implicit in the lease will be comparable to a bank loan.
Explanation for Choice B:
If the lessee is operating unprofitably, it may not be able to make use of the depreciation
write-off of ownership, whereas the lessor should be able to take advantage of it and
could pass some of the tax benefits back to the lessee in the form of lower lease
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Section B - Corporate Finance.
Answers
payments. In such a circumstance, leasing the equipment could be of more benefit to
the lessee than purchasing the equipment.
Explanation for Choice D:
The time in which the asset becomes obsolete is relevant in the decision as to how to
finance the purchase. If there is a short time until the equipment becomes obsolete, the
company is more likely to lease the asset. If they took out a loan, they may be paying
back the loan after the asset has already stopped being useful. This is not the proper
timing of cash flows if they are paying for something that they are not benefiting from.
213. Question ID: CMA 693 1.5 (Topic: Raising Capital)
The term "underwriting spread" refers to the

 A. Difference between the price the investment banker pays for a new security issue and
the price at which the securities are resold.correct
 B. Commission percentage an investment banker receives for underwriting a security
issue.
 C. Discount investment bankers receive on securities they purchase from the issuing
company.
 D. Commission a broker receives for either buying or selling a security on behalf of an
investor.
Question was not answered
Correct Answer Explanation:
The underwriting spread is the difference between the price the investment banker pays
the issuer for a new security issue and the price at which the investment banker then
sells the securities to the public. The underwriting spread is the profit that is earned by
the underwriter on the transaction.
Explanation for Choice B:
The underwriting spread is not a commission that is received by the underwriter.
Commissions are based on the selling price, and the underwriting spread is not a
percentage of the selling price.
Explanation for Choice C:
While the underwriting spread is somewhat similar to a discount, it is not a discounted
price, but rather the difference between what the underwriter pays for the securities and
sell the securities for.
Explanation for Choice D:
The underwriting spread is not a commission that the underwriter receives for buying or
selling a security on behalf of an investor. See the correct answer for a complete
explanation.
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214. Question ID: CMA 693 P1 Q7 (Topic: Raising Capital)
When a company desires to increase the market value per share of common stock, the
company will

 A. Implement a reverse stock split.correct

 B. Sell treasury stock.
 C. Sell preferred stock.
 D. Split the stock.
Question was not answered
Correct Answer Explanation:
In a reverse stock split the company reduces the number of shares outstanding. For
example, in a 1-for-2 reverse stock split, every two shares that are held by someone
become one share. This one share, however, has a value that is twice as high as an
individual share before the reverse stock split. Therefore, a reverse stock split will
increase the market value of a common share.
Explanation for Choice B:
If the company sells treasury shares there are more shares outstanding to which the
value of the company needs to be divided. A sale of treasury shares will reduce the
value of an individual common share.
Explanation for Choice C:
Selling preferred stock will have only an indirect effect on the market value of common
stock, and it would decrease the common stock's market value, not increase it.
Preferred stock reduces the income available to common shareholders which in turn
reduces basic and diluted earnings per share. The reduction of earnings per share
would reduce the value of the common stock in the judgment of the market, so the
market value of the common stock could decline. It would not increase.
Explanation for Choice D:
In a stock split each share is split into some number of more shares. For example, in a
2-for-1 split, each share that is held by someone becomes two shares. However, the
market value of each of those shares is half what it had been before the split. A stock
split reduces the market value of each common share. It does not increase it.
215. Question ID: CMA 694 1.19 (Topic: Cash and Marketable Securities
Management)
A company has daily cash receipts of $150,000. The treasurer of the company has
investigated a lockbox service whereby the bank that offers this service will reduce the
company's collection time by four days at a monthly fee of $2,500. If money market
rates average 4% during the year, the additional annual income (loss) from using the
lockbox service would be
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Section B - Corporate Finance.
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 A. $(12,000)
 B. $(6,000)correct
 C. $12,000
 D. $6,000
Question was not answered
Correct Answer Explanation:
By reducing the collection time by 4 days, the company will increase its average cash
balance by $600,000 ($150,000 × 4). This will earn the company $24,000 in interest
during the year. However, the cost of the new system is $2,500 per month, or $30,000
per year. Therefore, the new system would have a net cost to the company of $6,000.
Explanation for Choice A:
By reducing the collection time by 4 days, the company will increase its average cash
balance by $600,000 ($150,000 × 4). That amount multiplied by the average money
market rate results in the amount of interest the company could earn during the year on
the increased cash balance, which is offset against the lockbox fee to calculate the net
income or loss from using the lockbox service.
This answer results from using 3 days of increases to the average cash balance to
calculate the amount of interest the company could earn.
Explanation for Choice C:
The lockbox service would cause a loss, not a gain, because the annual fees would be
greater than the interest income that could be earned on the increased investable
balances.
Explanation for Choice D:
The lockbox service would cause a loss, not a gain, because the annual fees would be
greater than the interest income that could be earned on the increased investable
balances.
216. Question ID: ICMA 19.P2.081 (Topic: Cash and Marketable Securities
Management)
A company holding cash for a speculative motive is holding cash to

 A. pay bills.
 B. take advantage of future investment opportunities.correct
 C. provide a safety margin.
 D. protect against uncollectible receivables.
Question was not answered
Correct Answer Explanation:
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Taking advantage of investment opportunities is the main example of why companies
hold cash for speculative purposes.
Explanation for Choice A:
Paying bills is not a speculative reason for holding cash.
Explanation for Choice C:
Holding cash to provide a safety margin is not a speculative reason for holding cash.
Explanation for Choice D:
Protecting against uncollectible receivables is not a speculative reason for holding cash.
217. Question ID: CMA 688 1.15 (Topic: Cash and Marketable Securities
Management)
The best example of a marketable security with minimal risk would be

 A. The commercial paper of an Aaa-rated company.correct

 B. Gold.
 C. Municipal bonds.
 D. The common stock of an Aaa-rated company.
Question was not answered
Correct Answer Explanation:
Of the choices provided, the commercial paper of a Aaa-rated company is the
marketable security that has the lowest risk. It has less risk than common stock
because the holders of debt have a preference over holders of common stock in the
distribution of assets in case of liquidation of the company. It has less risk than
municipal bonds, even municipal bonds that may be Aaa rated, because commercial
paper is very short-term debt. There is much less chance of something happening to
change the financial condition of the issuer and the rating of a short-term debt
instrument than there is of something happening to change the financial condition of the
issuer and the rating of a long-term debt instrument like a municipal bond, simply
because there is less time for something like that to happen. Therefore, Aaa rated
commercial paper carries less risk than municipal bonds.
Explanation for Choice B:
Gold is not a marketable security.
Explanation for Choice C:
Bonds are longer-term debt, and longer-term debt carries more risk than short-term debt
because there is more time for something to happen that could change the financial
condition of the issuer and its ability to repay the debt.
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Explanation for Choice D:
In the case of liquidation, common stockholders are the last in the list of recipients of the
cash of the company. Therefore, it has more risk than securities whose holders have a
higher priority in the case of liquidation.
218. Question ID: CMA 692 1.27 (Topic: Cash and Marketable Securities
Management)
The following information applies to Brandon Company:

Purchases Sales
January $160,000 $100,000
February 160,000 200,000
March 160,000 240,000
April 140,000 300,000
May 140,000 260,000
June 120,000 240,000
A cash payment equal to 40% of purchases is made at the time of purchase, and 30%
is paid in each of the next 2 months. Purchases for the previous November and
December were $150,000 per month. Payroll is 10% of sales in the month it occurs, and
operating expenses are 20% of the following month's sales (July sales were $220,000).
Interest payments were $20,000 paid quarterly in January and April. Brandon's cash
disbursements for the month of April were

 A. $200,000.
 B. $152,000.
 C. $254,000.correct
 D. $140,000.
Question was not answered
Correct Answer Explanation:
Brandon had cash disbursements in April related to the following items:

30% of February purchases of $160,000 $ 48,000

30% of March purchases of $160,000 48,000
40% of April purchases of $140,000 56,000
Payroll: 10% of April sales of $300,000 30,000
 Hock P2 2020
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Operating expenses: 20% of May sales of $260,000 52,000
Interest payment 20,000
Total $254,000
Total cash disbursements were $254,000 in April.
Explanation for Choice A:
This answer could result from including 10% of April's purchases for payroll
disbursements instead of 10% of April sales, and 10% of May's purchases for operating
expense disbursements instead of 20% of May's sales.
Explanation for Choice B:
This answer includes only the cash payments for the items purchased for resale. See
the correct answer for a complete explanation.
Explanation for Choice D:
This is the amount of purchases made during April. The question asks for cash
disbursements made during April, not the amount of purchases.
219. Question ID: CMA 694 1.25 (Topic: Cash and Marketable Securities
Management)
All of the following are alternative marketable securities suitable for short-term
investment except

 A. Commercial paper.
 B. Convertible bonds.correct
 C. U.S. Treasury bills.
 D. Eurodollar time deposits.
Question was not answered
Correct Answer Explanation:
Short-term marketable securities are highly liquid investments that are used for short-
term investments. Such securities will generally have highly liquid markets allowing the
security to be sold at a reasonable price very quickly. Although they are marketable,
since there is a secondary market for them, convertible bonds (and bonds in general)
are usually a longer term investment.
Explanation for Choice A:
Commercial paper is marketable, short-term unsecured debt issued by large companies
with solid credit histories and high credit ratings. It is issued in denominations of
$100,000 or more and is sold to companies and institutional investors. Although
commercial paper is a marketable security, it has a very small secondary market
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because most commercial paper is very short-term and most buyers hold it until it
matures. However, it is an example of a marketable security that is a suitable short-term
investment.
Explanation for Choice C:
U.S. Treasury bills are short-term U.S. government securities and are an example of a
marketable security that is suitable short-term investment.
Explanation for Choice D:
Eurodollars are deposits denominated in U.S. dollars that are deposited in banks
located outside of the U.S. Eurodollar deposits are for a minimum of $100,000 and
usually are in the millions of dollars. Eurodollar time deposits are like negotiable
certificates of deposit in the U.S. Most have maturity dates of less than a year, plus they
have a secondary market and can be sold prior to their maturity. Therefore, they are an
example of a marketable security that is a suitable short-term investment.
220. Question ID: CMA 1295 1.14 (Topic: Cash and Marketable Securities
Management)
Foster Inc. is considering implementing a lock-box collection system at a cost of
$80,000 per year. Annual sales are $90 million, and the lockbox system will reduce
collection time by 3 days. If Foster can invest funds at 8%, should it use the lockbox
system? Assume a 360-day year.

 A. Yes, producing savings of $140,000 per year.

 B. No, producing a loss of $60,000 per year.
 C. Yes, producing savings of $60,000 per year.
 D. No, producing a loss of $20,000 per year.correct
Question was not answered
Correct Answer Explanation:
If Foster uses the lockbox system, the fee for the system will be $80,000 per year.
The savings from the system will be calculated as follows: sales per day are $250,000
($90,000,000 ÷ 360), and the company will collect payments three days faster. This will
increase their average cash balance by $750,000 ($250,000 × 3). The interest earned
over a period of a year on this amount is only $60,000 ($750,000 × 8%). Since the cost
of the system is $20,000 more than the benefits from the system, Foster should not
implement the system.
Explanation for Choice A:
$140,000 is the sum of the cost of the lockbox and the interest to be earned from having
the additional investable funds. The net benefit or loss of the lockbox system is the
difference between the two amounts, not their sum.
 Hock P2 2020
Section B - Corporate Finance.
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Explanation for Choice B:
$60,000 is the amount of additional interest that is earned during the period. See the
correct answer for a complete explanation.
Explanation for Choice C:
$60,000 is the amount of interest the company will earn on the additional investable
funds. However, the company will have a cost for the lockbox that will offset the
additional interest.
221. Question ID: CMA 697 1.13 (Topic: Cash and Marketable Securities
Management)
Newman Products has received proposals from several banks to establish a lockbox
system to speed up receipts. Newman receives an average of 700 checks per day
averaging $1,800 each, and its cost of short-term funds is 7% per year. Assuming that
all proposals will produce equivalent processing results and using a 360-day year,
which one of the following proposals is optimal for Newman?

 A. A $0.50 fee per check.

 B. A fee of 0.03% of the amount collected.
 C. A flat fee of $125,000 per year.
 D. A compensating balance of $1,750,000.correct
Question was not answered
Correct Answer Explanation:
This is the correct answer. By keeping a compensating balance of $1,750,000, Newman
will lose $122,500 per year in interest ($1,750,000 × 0.07), so the cost of this option,
which is an opportunity cost, is $122,500. This is a lower cost than any of the other
options and is therefore the optimal solution for Newman. The costs of the other options
are as follows:
A $0.50 fee per check would result in a cost of $126,000 per year (700 checks a day ×
$0.50 per check × 360 days in a year), which is higher than the $122,500 cost of the
compensating balance.
A flat fee of $125,000 per year would be higher than the $122,500 cost of the
compensating balance.
A fee of 0.03% of the amount collected would result in a cost of $136,080 per year
(average check amount of $1,800 × 700 checks per day × 0.0003 × 360 days in a year),
which is higher than the $122,500 cost of the compensating balance.
Explanation for Choice A:
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Section B - Corporate Finance.
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The cost of this proposal is $126,000 per year (700 checks a day × $0.50 per check ×
360 days in a year). This is not the lowest-cost proposal so it is not the optimal proposal
for Newman.
Explanation for Choice B:
The cost of this proposal is $136,080 per year ($1,800 per check × 700 checks per day
× 0.0003 × 360 days in a year). This is not the lowest-cost proposal so it is not the
optimal proposal for Newman.
Explanation for Choice C:
The annual cost of this proposal is $125,000. This is not the lowest-cost proposal so it is
not the optimal proposal for Newman.
222. Question ID: CMA 691 1.10 (Topic: Cash and Marketable Securities
Management)
Commercial paper

 A. Is usually sold only through investment banking dealers.

 B. Ordinarily does not have an active secondary market.correct
 C. Has a maturity date greater than 1 year.
 D. Has an interest rate lower than Treasury bills.
Question was not answered
Correct Answer Explanation:
Commercial paper does not usually have an active secondary market on which it is
bought and sold after the original issuance primarily because the terms of commercial
paper are very short and most buyers of commercial paper purchase paper with
maturities that coincide with their need for money. Therefore, most holders of
commercial paper hold it until it matures. However, if the holder of commercial paper
needs the money sooner, the commercial paper can usually be sold back to the issuer,
if it was directly placed, or to the dealer it was purchased from, if it is dealer paper.
Explanation for Choice A:
Commercial paper is usually sold either directly to investors by the company that is
issuing it, or the issuer sells it initially to a commercial paper dealer who in turn sells it to
investors. Investment bankers do not get involved in selling commercial paper.
Explanation for Choice C:
Commercial paper usually has a maturity of less than 270 days. If it is less than 270
days it is able to avoid registration requirements.
Explanation for Choice D:
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Because commercial paper has more risk that Treasury bills, the interest rate on the
commercial paper is higher than on Treasury bills.
223. Question ID: ICMA 10.P2.140 (Topic: Cash and Marketable Securities
Management)
All of the following are reasons for holding cash except for the

 A. motive to meet future needs.

 B. precautionary motive.
 C. transaction motive.
 D. motive to make a profit.correct
Question was not answered
Correct Answer Explanation:
Cash is not held to make a profit. Unless it is being held for transactions, precautions, or
as a compensating balance requirement it can be put to better use in an interest earning
option.
Explanation for Choice A:
Cash may be held in order to be able to act quickly on good investment opportunities
that arise. This can take the form of an acquisition of another company or something
simpler such as the purchase of inventory at a deeply discounted price.
Explanation for Choice B:
Cash may be held for use in unforeseen situations where cash is needed quickly.
Explanation for Choice C:
Cash is needed to conduct day-to-day business transactions.
224. Question ID: CMA 697 1.20 (Topic: Cash and Marketable Securities
Management)
Kemple is a newly established janitorial firm, and the owner is deciding what type of
checking account to open. Kemple is planning to keep a $500 minimum balance in the
account for emergencies and plans to write roughly 80 checks per month. The bank
charges $10 per month plus a $0.10 per check charge for a standard business checking
account with no minimum balance. Kemple also has the option of a premium business
checking account that requires a $2,500 minimum balance but has no monthly fees or
per check charges. If Kemple's cost of funds is 10%, which account should Kemple
choose?

 A. Premium account, because the savings is $34 per year.

 B. Standard account, because the savings is $34 per year.
 C. Standard account, because the savings is $16 per year.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 D. Premium account, because the savings is $16 per year.correct
Question was not answered
Correct Answer Explanation:
Under the Premium account, the cost for Kemple would be $200. This is the interest
that would be lost on the additional $2,000 that Kemple must add to the account in order
to maintain the minimum balance of $2,500. This needs to be compared to the cost of
the Standard account. The Standard account has a cost of $10 per month ($120 total)
plus $8 a month for checks that are written ($96 in total). Therefore, the total cost of the
Standard account is $216, which is $16 more than the Premium account.
Explanation for Choice A:
This answer assumes that there will be an interest cost on the full $2,500 that needs to
be maintained as the minimum balance on the Premium account. Actually, interest is
calculated only on the $2,000 that Kemple would need to keep in the account that is in
excess of what they already keep in that account. Furthermore, this answer reverses
which account costs less.
Explanation for Choice B:
This answer assumes that there will be an interest cost on the full $2,500 that needs to
be maintained as the minimum balance on the Premium account. Actually, interest is
calculated only on the $2,000 that Kemple would need to keep in the account that is in
excess of what they already keep in that account. See the correct answer for a
complete explanation.
Explanation for Choice C:
This answer reverses which account costs less.
225. Question ID: CMA 694 1.22 (Topic: Cash and Marketable Securities
Management)
All of the following are valid reasons for a business to hold cash and marketable
securities except to

 A. Maintain adequate cash needed for transactions.

 B. Meet future needs.
 C. Earn maximum returns on investment assets.correct
 D. Satisfy compensating balance requirements.
Question was not answered
Correct Answer Explanation:
Cash and marketable securities provide very little (if any) return. This is not a valid
reason for holding cash and marketable securities.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice A:
Holding enough cash for cash transactions is a valid reason for holding cash.
Explanation for Choice B:
A valid reason for holding cash is to meet future cash needs.
Explanation for Choice D:
Holding cash to maintain compensating balance requirements is a valid reason for
holding cash.
226. Question ID: ICMA 10.P2.145 (Topic: Cash and Marketable Securities
Management)
The Rolling Stone Corporation, an entertainment ticketing service, is considering the
following means of speeding cash flow for the corporation.

 Lock Box System. This would cost $25 per month for each of its 170 banks and
would result in interest savings of $5,240 per month.

 Drafts. Drafts would be used to pay for ticket refunds based on 4,000 refunds per
month at a cost of $2.00 per draft, which would result in interest savings of $6,500
per month.

 Bank Float. Bank float would be used for the $1,000,000 in checks written each
month. The bank would charge a 2% fee for this service, but the corporation will
earn $22,000 in interest on the float.

 Electronic Transfer. Items over $25,000 would be electronically transferred; it is

estimated that 700 items of this type would be made each month at a cost of $18
each, which would result in increased interest earnings of $14,000 per month.
Which of these methods of speeding cash flow should Rolling Stone Corporation adopt?

 A. Lock box, bank float, and electronic transfer only.correct

 B. Lock box, drafts, and electronic transfer only.
 C. Lock box and electronic transfer only.
 D. Bank float and electronic transfer only.
Question was not answered
Correct Answer Explanation:
The correct way to solve this is to work out the net increase or decrease in operating
income that would result from the use of each of the four methods. Those that result in
increased operating income should be used, and those that result in decreased
 Hock P2 2020
Section B - Corporate Finance.
Answers
operating income should not be used. The lock box, bank float and electronic transfer
methods would all result in increased operating income.
The cost of the lock box system would be $25 × 170, or $4,250 per month. It would
result in interest savings of $5,240 per month, so the increase in operating income
attributable to the lock box system would be $5,240 − $4,250, or $990. Thus, the lock
box system should be used.
The cost of the drafts would be $2 × 4,000, or $8,000 per month. It would result in
interest savings of $6,500 per month, so the change in operating income attributable to
the drafts would be $6,500 − $8,000, a $(1,500) loss. Thus, the drafts should not be
used.
The cost of the bank float would be $1,000,000 × 0.02, or $20,000 per month. The
interest earned on the float would be $22,000 per month. So the increase in operating
income attributable to the use of the bank float would be $22,000 − $20,000, or $2,000.
Thus, the bank float should be used.
The cost of electronic transfers would be $18 × 700, or $12,600 per month. The
increased interest earnings would be $14,000 per month. The increase in operating
income attributable to the use of electronic transfers would be $14,000 − $12,600, or
$1,400. Thus, the electronic transfers should be used.
Explanation for Choice B:
The correct way to solve this is to work out the net increase or decrease in operating
income that would result from the use of each of the four methods. Those that result in
increased operating income should be used, and those that result in decreased
operating income should not be used. Not all of these methods would provide increased
operating income; and this group does not include all of the methods that would provide
increased operating income.
Explanation for Choice C:
The correct way to solve this is to work out the net increase or decrease in operating
income that would result from the use of each of the four methods. Those that result in
increased operating income should be used, and those that result in decreased
operating income should not be used. These are not the only methods that would
provide increased operating income.
Explanation for Choice D:
The correct way to solve this is to work out the net increase or decrease in operating
income that would result from the use of each of the four methods. Those that result in
increased operating income should be used, and those that result in decreased
operating income should not be used. These are not the only methods that would
provide increased operating income.
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Answers
227. Question ID: ICMA 10.P2.139 (Topic: Cash and Marketable Securities
Management)
A firm uses the following model to determine the optimal average cash balance (Q).

An increase in which one of the following would result in a decrease in the optimal
cash balance?

 A. Uncertainty of cash outflows.

 B. Cost of a security trade.
 C. Cash requirements for the year.
 D. Return on marketable securities.correct
Question was not answered
Correct Answer Explanation:
An increase in the return on marketable securities would increase the opportunity cost
of holding cash instead of investing it in marketable securities. When the opportunity
cost of holding cash increases, the amount of cash a business will want to hold will
decrease. That is because an increase in the denominator of the fraction under the
radical sign will decrease the value of the fraction, thereby decreasing the square root of
the value and the optimal average cash balance.
The formula given is the Baumol Cash Management Model. Using the Baumol Cash
Management Model, this answer can be illustrated by assigning some values to it. Let’s
say the cost per sale of a T-Bill is $20 (that is the commission paid, or the fixed cost per
transaction to convert a T-Bill into cash). And let’s say the annual cash disbursement
amount, or the total demand for cash for the period, is $50,000. And let’s say the
interest rate on marketable securities is 2%, or 0.02.
The optimal cash balance will be the square root of [(2 × 20 × 50,000) / 0.02]:
(2 × 20 × 50,000) = 2,000,000.
2,000,000 / 0.02 = 100,000,000.
The square root of 100,000,000 = $10,000.
Now, let’s increase the interest rate on marketable securities to 3%, or 0.03:
2,000,000 / 0.03 = 66,666,666.67.
The square root of 66,666,666.67 = $8,165.
So because the interest rate has increased, the optimal cash balance has decreased
from $10,000 to $8,165.
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Section B - Corporate Finance.
Answers
Explanation for Choice A:
The formula given is the Baumol Cash Management Model. The uncertainty of cash
outflows is a fact that limits the effectiveness of the Baumol Cash Management Model. It
does not result in either an increase or a decrease in the optimal cash balance
calculated using the model.
Explanation for Choice B:
The formula given is the Baumol Cash Management Model. An increase in the cost of a
security trade would cause an increase, not a decrease, in the optimal cash balance
according to the model. That is because an increase in the numerator of the fraction
under the radical sign will increase the value of the fraction, thereby increasing the
square root of the value and the optimal average cash balance.
Using the Baumol Cash Management Model, this can be illustrated by assigning some
values to it. Let’s say the cost per sale of a T-Bill is $20 (that is the commission paid, or
the fixed cost per transaction to convert a T-Bill into cash). And let’s say the annual
cash disbursement amount, or the total demand for cash for the period, is $50,000. And
let’s say the interest rate on marketable securities is 2%, or 0.02.
The optimal cash balance will be the square root of [(2 × 20 × 50,000) / 0.02]:
(2 × 20 × 50,000) = 2,000,000.
2,000,000 / 0.02 = 100,000,000.
The square root of 100,000,000 = $10,000.
Now, let's increase the cost per sale of a T-Bill to $30.
The optimal cash balance will be the square root of [(2 × 30 × 50,000) / 0.02]:
(2 × 30 × 50,000) = 3,000,000.
3,000,000 / 0.02 = 150,000,000.
The square root of 150,000,000 = $12,247.
So because the cost per sale of a T-Bill has increased, the optimal cash balance has
also increased from $10,000 to $12,247. It has not decreased.
Explanation for Choice C:
The formula given is the Baumol Cash Management Model. An increase in the cash
requirements for the year would cause an increase, not a decrease, in the optimal cash
balance according to the model. That is because an increase in the numerator of the
fraction under the radical sign will increase the value of the fraction, thereby increasing
the square root of the value and the optimal average cash balance.
Using the Baumol Cash Management Model, this can be illustrated by assigning some
values to it. Let’s say the cost per sale of a T-Bill is $20 (that is the commission paid, or
the fixed cost per transaction to convert a T-Bill into cash). And let’s say the annual
cash disbursement amount, or the total demand for cash for the period, is $50,000. And
let’s say the interest rate on marketable securities is 2%, or 0.02.
 Hock P2 2020
Section B - Corporate Finance.
Answers
The optimal cash balance will be the square root of [(2 × 20 × 50,000) / 0.02]:
(2 × 20 × 50,000) = 2,000,000.
2,000,000 / 0.02 = 100,000,000.
The square root of 100,000,000 = $10,000.
Now, let's increase the cash requirements for the year to $75,000.
The optimal cash balance will be the square root of [(2 × 20 × 75,000) / 0.02]:
(2 × 20 × 75,000) = 3,000,000.
3,000,000 / 0.02 = 150,000,000.
The square root of 150,000,000 = $12,247.
So because the cash requirements for the year have increased, the optimal cash
balance has also increased from $10,000 to $12,247. It has not decreased.
228. Question ID: CMA 694 1.24 (Topic: Cash and Marketable Securities
Management)
Assume that each day a company writes and receives checks totaling $10,000. If it
takes 2 days for the checks to clear and be deducted from the company's account and
only 1 day for the deposits to clear, what is the net float?

 A. $(10,000)
 B. $20,000
 C. $10,000correct
 D. $0
Question was not answered
Correct Answer Explanation:
When a company writes a check, there is a period of time between when the check is
written and when the money is taken out of the company's bank account. This gives the
company an interest free loan that the company receives from a supplier because while
they have in essence paid the money, but they still have the money.
Similarly, when a company receives a check, there is a delay between the time the
check is received and the money is deposited in their account and the bank collects the
funds so the company can use them. This is an interest free loan that the company is
giving to their customers.
If the delay for checks written is greater than the delay for checks that are deposited,
the company has a net interest free loan equal to the amount of the checks written each
day multiplied by the number of days' delay minus the amount of the checks deposited
each day multiplied by the number of days' delay. This is called the net float. In this
question, the net float is ($10,000 × 2) − ($10,000 × 1), or $10,000.
Explanation for Choice A:
 Hock P2 2020
Section B - Corporate Finance.
Answers
When a company writes a check, there is a period of time between when the check is
written and when the money is taken out of the company's bank account. This gives the
company an interest free loan that the company receives from a supplier because while
they have in essence paid the money, they still have the money.
Similarly, when a company receives a check, there is a delay between the time the
check is received and the money is deposited in their account and the bank collects the
funds so the company can use them. This is an interest free loan that the company is
giving to their customers.
If the delay for checks written is greater than the delay for checks that are deposited,
the company has a net interest free loan equal to the amount of the checks written each
day multiplied by the number of days' delay minus the amount of the checks deposited
each day multiplied by the number of days' delay. This is called the net float.
In this question, the net float would be ($10,000) only if the checks deposited took a day
longer to be collected than the checks written, because the company would be in the
position of giving a net loan to its customers equal to $10,000 × 1. However, in this
question the checks written take a day longer to clear than the checks deposited.
Explanation for Choice B:
When a company writes a check, there is a period of time between when the check is
written and when the money is taken out of the company's bank account. This gives the
company an interest free loan that the company receives from a supplier because while
they have in essence paid the money, they still have the money.
Similarly, when a company receives a check, there is a delay between the time the
check is received and the money is deposited in their account and the bank collects the
funds so the company can use them. This is an interest free loan that the company is
giving to their customers.
If the delay for checks written is greater than the delay for checks that are deposited,
the company has a net interest free loan equal to the amount of the checks written each
day multiplied by the number of days' delay minus the amount of the checks deposited
each day multiplied by the number of days' delay. This is called the net float.
In this question, the company's interest free interest free loan is equal to $20,000
($10,000 × 2 days). But the interest free loans it is extending to its customers are
$10,000 ($10,000 × 1 day). The net float is the difference between the two amounts.
Explanation for Choice D:
When a company writes a check, there is a period of time between when the check is
written and when the money is taken out of the company's bank account. This gives the
company an interest free loan that the company receives from a supplier because while
they have in essence paid the money, they still have the money.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Similarly, when a company receives a check, there is a delay between the time the
check is received and the money is deposited in their account and the bank collects the
funds so the company can use them. This is an interest free loan that the company is
giving to their customers.
If the delay for checks written is greater than the delay for checks that are deposited,
the company has a net interest free loan equal to the amount of the checks written each
day multiplied by the number of days' delay minus the amount of the checks deposited
each day multiplied by the number of days' delay. This is called the net float.
In this question, the net float would be zero only if the checks deposited in the amount
of $10,000 required the same number of days to clear as the checks written in the
amount of $10,000. But the checks written take one day longer to clear than the checks
deposited.
229. Question ID: CMA 1291 1.17 (Topic: Cash and Marketable Securities
Management)
Obligations issued by federal agencies other than the U.S. Treasury Department are

 A. Guaranteed by the U.S. government but not by the agency issuing the security.
 B. Guaranteed by the agency issuing the security but not by the U.S. government.correct
 C. Guaranteed neither by the agency issuing the security nor by the U.S. government.
 D. Not easily marketed.
Question was not answered
Correct Answer Explanation:
Obligations that are issued by a federal agency other than the U.S. Treasury
Department are not guaranteed by the U.S. government. They are guaranteed by the
agency that issued them but not by the U.S. government.
Explanation for Choice A:
Federal agency obligations not issued by the U.S. Treasury Department are not
guaranteed by the U.S. government, but they are guaranteed by the agency that issued
the obligations.
Explanation for Choice C:
Federal agency obligations issued by an agency other than the U.S. Treasury are
guaranteed by the agency issuing the obligations.
Explanation for Choice D:
Obligations that are issued by a federal agency of the U.S. government are easily
marketable.
 Hock P2 2020
Section B - Corporate Finance.
Answers
230. Question ID: ICMA 10.P2.196 (Topic: Cash and Marketable Securities
Management)
Garner Products is considering a new accounts payable and cash disbursement
process which is projected to add 3 days to the disbursement schedule without having
significant negative effects on supplier relations. Daily cash outflows average
$1,500,000. Garner is in a short-term borrowing position for 8 months of the year and in
an investment position for 4 months. On an annual basis, bank lending rates are
expected to average 7% and marketable securities yields are expected to average 4%.
What is the maximum annual expense that Garner could incur for this new process and
still break even?

 A. $180,000.
 B. $270,000.correct
 C. $90,000.
 D. $315,000.
Question was not answered
Correct Answer Explanation:
The total amount saved by the new accounts payable and cash disbursement process
will be $1,500,000 × 3 days, or $4,500,000. That will be the average balance of added
cash that will be available to Garner every day of the year.
The company is in a borrowing position for 8 months of the year. So the amount of
added cash will decrease the amount that the company needs to borrow and thus will
decrease its interest expense for 8 months of the year. The company’s borrowing rate is
7%. So the annual amount of decrease in the company’s interest expense will be
$4,500,000 × 0.07 ÷ 12 × 8, or $210,000.
The company is in an investment position for 4 months of the year. So the amount of
added cash will increase the amount that the company can invest and thus will increase
its interest income for 4 months of the year. The company’s average yield on funds
invested in marketable securities is 4%. So the annual amount of increase in the
company’s interest income will be $4,500,000 × 0.04 ÷ 12 × 4, or $60,000.
The amount of the annual decrease in interest expense plus the amount of the annual
increase in interest income will be the amount of annual increased net income that
Garner can expect as a result of the new accounts payable and cash disbursement
process. That will be $210,000 + $60,000, or $270,000. So the maximum annual
expense that Garner could incur for the new process and still break even would be
equal to the annual increase in net income from the process, or $270,000.
Explanation for Choice A:
This answer results from using the daily cash outflow amount of $1,500,000 multiplied
by 2 to calculate the amount of net income expected as a result of the new accounts
 Hock P2 2020
Section B - Corporate Finance.
Answers
payable and cash disbursement process. However, the company will be adding that
amount for each of 3 days to its available cash balance, not just for 2 days.
Explanation for Choice C:
This answer results from using the daily cash outflow amount of $1,500,000 to calculate
the amount of net income expected as a result of the new accounts payable and cash
disbursement process. However, the company will be adding that amount for each of 3
days to its available cash balance, not just for 1 day.
Explanation for Choice D:
This answer results from using the 7% borrowing rate to calculate the amount of
increase in net income from the new accounts payable and cash disbursement system.
However, the 7% borrowing rate will be applicable for only 8 months of the year. For the
other 4 months, the applicable rate will be the average yield rate on marketable
securities.
231. Question ID: CMA 1295 1.12 (Topic: Cash and Marketable Securities
Management)
When managing cash and short-term investments, a corporate treasurer is primarily
concerned with

 A. Minimizing taxes.
 B. Maximizing rate of return.
 C. Investing in Treasury bonds since they have no default risk.
 D. Liquidity and safety.correct
Question was not answered
Correct Answer Explanation:
The management of short-term investments is based on liquidity and safety. Liquidity is
how easily the short-term investments can be converted into cash without significant
loss of principal, and safety refers to the likelihood that the issuer will be able to make
the promised payments of interest and principal.
Explanation for Choice A:
The minimization of taxes is not the primary concern of managing cash and short-term
investments.
Explanation for Choice B:
The maximization of return is not the primary concern of managing cash and short-term
investments.
Explanation for Choice C:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This answer is incorrect because treasury bonds are not liquid enough to be used as a
short-term investment. Liquid assets are those that can be converted into cash in a
short period of time without significant loss of principal. Because they have long-term
maturities, treasury bonds are vulnerable to loss of principal in a period of rising interest
rates. See the correct answer for a complete explanation.
232. Question ID: CMA Sample Q1.6 (Topic: Cash and Marketable Securities
Management)
Cleveland Masks and Costumes Inc. (CMC) has a majority of its customers located in
the states of California and Nevada. Keystone National Bank, a major west coast bank,
has agreed to provide a lockbox system to CMC at a fixed fee of $50,000 per year and
a variable fee of $0.50 for each payment processed by the bank. On average, CMC
receives 50 payments per day, each averaging $20,000. With the lockbox system, the
company's collection float will decrease by 2 days. The annual interest rate on money
market securities is 6%.
If CMC makes use of the lockbox system, what would be the net benefit to the
company? Use 365 days per year.

 A. $120,000
 B. $59,125
 C. $50,000
 D. $60,875correct
Question was not answered
Correct Answer Explanation:
If the company implemented the lockbox system, they would receive additional interest
on the funds that would be collected earlier. The collections per day is $1,000,000 and
since they would collect money 2 days faster, their cash balance during the year would
be $2,000,000 higher. At a 6% interest rate, this is equal to $120,000 of interest income
they would receive. The cost would be $50,000 per year plus $0.50 for each payment
processed. They receive 50 payments per day, for a cost of $25 per day. For the year
this is $9,125, bringing the total cost of the system to $59,125. This is $60,875 less than
the income from the system so the benefit of the system is $60,875.
Explanation for Choice A:
$120,000 is the benefit received from investing the additional cash generated by the
lockbox system, but it does not include consideration of the cost of the service. See the
correct answer for a complete explanation.
Explanation for Choice B:
$59,125 is the cost of the lockbox system for one year, but it does not include
consideration of the benefit from being able to invest the additional cash generated by
the lockbox. See the correct answer for a complete explanation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice C:
$50,000 is simply the annual fee that needs to be paid. See the correct answer for a
complete explanation.
233. Question ID: CMA 684 1.5 (Topic: Cash and Marketable Securities
Management)
When a company is evaluating whether the ratio of cash and marketable securities to
total assets should be high or low, its decision will be based upon

 A. Risk-profitability trade-off considerations.correct

 B. Flotation cost considerations.
 C. Financial leverage considerations.
 D. Operating leverage considerations.
Question was not answered
Correct Answer Explanation:
Any working capital management decision that a company makes should be based on
the cost/benefit of the situation. By having more cash and marketable securities, there is
less chance of default, but there is also a lower rate of return since short-term assets
provide little, if any, return.
Explanation for Choice B:
Flotation costs are costs connected to the issuance of debt or equity. They are not
related to this question.
Explanation for Choice C:
Financial leverage is concerned with the amount of debt that a company has. It is not
relevant to this situation.
Explanation for Choice D:
Operating leverage is related to the amount of fixed costs that the company has. It is not
relevant to this question.
234. Question ID: ICMA 10.P2.146 (Topic: Cash and Marketable Securities
Management)
JKL Industries requires its branch offices to transfer cash balances once per week to
the central corporate account. A wire transfer costs $12 and assures the cash is
available the same day. A depository transfer check (DTC) costs $1.50 and generally
results in funds being available in 2 days. JKL’s cost of short-term funds averages 9%,
and they use a 360-day year in all calculations. What is the minimum transfer amount
that would justify the cost of a wire transfer as opposed to a DTC?

 A. $42,000.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 B. $21,000.correct
 C. $27,000.
 D. $24,000.
Question was not answered
Correct Answer Explanation:
In order for the wire transfer cost to be justified, the interest earned by investing the
funds 2 days earlier needs to be equal to or greater than the difference between the
cost for the wire transfer ($12.00) and the cost for the depository transfer check ($1.50),
which is $10.50. We know the interest rate (9%) and the amount of time (2 days), so we
need to find the investable funds balance that will result in interest of $10.50 for two
days.
We will let "InvBal" be our unknown. The formula is:
InvBal × 0.09 ÷ 360 × 2 = $10.50
Solving for InvBal:
First, we can simplify the equation by performing the mathematics, i.e., multiplying and
dividing 0.09 ÷ 360 × 2. When we do that, we get 0.0005.
Now, our formula looks like this:
InvBal × 0.0005 = $10.50
InvBal = 10.50 ÷ 0.0005
InvBal = $21,000
So the minimum transfer amount that would justify the cost of a wire transfer as
opposed to a DTC is $21,000.
Explanation for Choice A:
This is the minimum transfer amount that would justify the cost of a wire transfer as
opposed to a DTC if using the wire transfer were to speed up the funds transfer by one
day. However, the funds transfer would be speeded up by two days.
Explanation for Choice C:
This is the minimum transfer amount that would justify the cost of a wire transfer as
opposed to a DTC if the difference in cost were $13.50 per transfer. The difference in
cost is only $10.50, because the current DTC cost is $1.50 per transfer, and the cost of
a wire transfer is $12.00.
Explanation for Choice D:
This is the minimum transfer amount that would justify the cost of a wire transfer as
opposed to a DTC if the difference in cost were $12.00 per transfer. The difference in
 Hock P2 2020
Section B - Corporate Finance.
Answers
cost is only $10.50, because the current DTC cost is $1.50 per transfer, and the cost of
a wire transfer is $12.00.
235. Question ID: CMA 691 1.12 (Topic: Cash and Marketable Securities
Management)
Which one of the following is not a characteristic of a negotiable certificate of deposit?
Negotiable certificates of deposit

 A. Are regulated by the Federal Reserve System.

 B. Have yields considerably greater than bankers' acceptances and commercial
paper.correct
 C. Have a secondary market for investors.
 D. Are usually sold in denominations of a minimum of $100,000.
Question was not answered
Correct Answer Explanation:
Negotiable certificates of deposit are less risky than both bankers' acceptances and
commercial paper. Therefore, their interest rate is lower.
Explanation for Choice A:
Negotiable certificates of deposit are deposits in banks, and banks are regulated by the
Federal Reserve System.
Explanation for Choice C:
Negotiable certificates of deposit do have a secondary market for investors.
Explanation for Choice D:
Negotiable certificates of deposit are issued for a minimum of $100,000.
236. Question ID: CMA 694 1.26 (Topic: Cash and Marketable Securities
Management)
Assuming a 360-day year, the current price of a $100,000 U.S. Treasury bill due in 180
days on a 6% discount basis is

 A. $93,000
 B. $97,000correct
 C. $100,000
 D. $94,000
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
When a U.S. Treasury bill is sold at a discount, that means that the interest that will be
due on the Treasury bill is subtracted from the face amount of the bill and the bill is sold
for the discounted amount. The full face value of the bill is repaid at maturity, and the
difference between the face value of the Treasury bill and the amount paid for it by the
investor is the interest.
Since this a 6%, 180 day bill we know that the interest for the period will be $3,000
($100,000 × 0.06 ÷ 2). Instead of selling the bill for $100,000 and then repaying the
$100,000 plus $3,000 of interest upon maturity, the bill is sold for $97,000 and $100,000
is repaid at maturity. In the discounting, the interest is deducted from the sale price of
the bill.
Explanation for Choice A:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
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in advance for helping us to make your HOCK study materials better.
Explanation for Choice C:
When the bill is sold at a discount, the interest that will be due to the buyer at the
maturity date is deducted at the time of the sale. See the correct answer for a complete
explanation.
Explanation for Choice D:
This answer includes an interest charge for an entire year. Since the bill is only 180
days, we only need one-half of the year's interest, or $3,000. See the correct answer for
a complete explanation.
237. Question ID: CMA 1294 1.17 (Topic: Cash and Marketable Securities
Management)
Troy Toys is a retailer operating in several cities. The individual store managers deposit
daily collections at a local bank in a non-interest bearing checking account. Twice per
week, the local bank issues a depository transfer check (DTC) to the central bank at
headquarters. The controller of the company is considering using a wire transfer
instead. The additional cost of each transfer would be $25; collections would be
accelerated by 2 days; and the annual interest rate paid by the central bank is 7.2%
(0.02% per day). At what amount of dollars transferred would it be economically feasible
to use a wire transfer instead of the DTC? Assume a 360-day year.

 A. $125,000 or above.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 B. Any amount greater than $62,500.correct
 C. It would never be economically feasible.
 D. Any amount greater than $173.
Question was not answered
Correct Answer Explanation:
This is an incremental analysis. In an incremental analysis, we look only at amounts that
will be different between the alternatives.
In this question we need to compare the interest that could be earned on the money for
the two additional days (which would not be earned if the money were transferred by
DTC) with the cost of the wire transfers, which would gain two additional days of interest
on each deposit. The cost of a wire transfer is $25. The interest that can be earned on
the money for the two additional days for each transfer (expressed as an interest rate) is
0.072 ÷ 360 × 2 = 0.0004, or 0.04%.
The amount of interest earned on each wire transfer will thus be 0.0004X, where X =
the amount of the transfer.
Next, we need to find what the transfer amount needs to be in order to earn more than
$25 in interest during the two extra days the money will be in an interest earning deposit
account. So our formula is:
0.0004X > $25
We solve for X by dividing both sides of the inequality by 0.0004, to isolate the X.
When we do this, we get X > $62,500.
Therefore, the amount of each transfer must be greater than $62,500, or it will not be
profitable to spend $25 to move the money faster.
We can check this as follows: $62,500 × 0.072 ÷ 360 × 2 = $25. In two days, Troy Toys
will receive $25 in interest on the amount of money deposited, if the amount is $62,500.
If Troy Toys is not able to transfer more than $62,500 each time, the company should
not change systems, as the cost of the new system will be greater than the benefit from
the new system.
Explanation for Choice A:
This answer assumes that the acceleration of collections is only 1 day instead of the two
days that it is. See the correct answer for a complete explanation.
Explanation for Choice C:
There is an amount at which the interest that can be saved on a reduction of borrowings
to be made with the deposited money is greater than the cost of the transfer. See the
correct answer for a complete explanation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice D:
This answer results from failing to divide the annual interest rate by 360 days before
multiplying it by 2 days. To find the interest rate for 2 days, the annual interest rate
should be divided by 360 and then multiplied by 2.
238. Question ID: CIA 593 IV.52 (Topic: Cash and Marketable Securities
Management)
Determining the amount and timing of conversions of marketable securities to cash is a
critical element of a financial manager's performance. In terms of the rate of return
forgone on converted securities and the cost of such transactions, the optimal amount
of cash to be raised by selling securities is

 A. Inversely related to the rate of return forgone and directly related to the cost of the
transaction.correct
 B. Directly related to the rate of return forgone and inversely related to the cost of the
transaction.
 C. Inversely related to the rate of return forgone and inversely related to the cost of the
transaction.
 D. Directly related to the rate of return forgone and directly related to the cost of the
transaction.
Question was not answered
Correct Answer Explanation:
The amount of cash that should be obtained through the sale of marketable securities is
calculated in order to balance the cost of the conversion and the lost return by having
the assets as cash instead of invested in a higher-return investment.
When two things are inversely related, when one increases, the other decreases and
vice versa. The higher the return is on marketable securities, the lower will be the
amount in cash that should be converted from securities at any one time, in order to
keep as much money as possible working and earning a return for as long as possible.
When two things are directly related, when one increases, the other also increases and
vice versa. The higher the cost is for a transaction to convert marketable securities to
cash, the larger should be the amount of marketable securities that will be converted to
cash each time a conversion is made, in order to minimize the overall transaction costs.
Explanation for Choice B:
When two things are directly related, when one increases, the other also increases and
vice versa. The optimal amount of cash to be raised by selling securities is not directly
related to the rate of return forgone because the company will want to keep as much
money as possible working and earning a return for as long as possible. Therefore, the
higher the return is on marketable securities, the lower should be the amount in cash
that will be converted from marketable securities to cash at any one time, which is an
 Hock P2 2020
Section B - Corporate Finance.
Answers
inverse relationship. When two things are inversely related, when one increases, the
other decreases and vice versa.
The relationship between the optimal amount of cash to be raised by selling securities is
not inversely related to the cost of the transaction. The higher the cost is for a
transaction, the larger should be the amount of marketable securities that will be
converted to cash each time a conversion is made, in order to minimize the overall
transaction costs. So this relationship is a direct relationship.
Explanation for Choice C:
When two things are inversely related, when one increases, the other decreases and
vice versa. The relationship between the optimal amount of cash to be raised by selling
securities is not inversely related to the cost of the transaction. The higher the cost is for
a transaction, the larger should be the amount of marketable securities that will be
converted to cash each time a conversion is made, in order to minimize the overall
transaction costs. So this relationship is a direct relationship.
Explanation for Choice D:
When two things are directly related, when one increases, the other also increases and
vice versa. The optimal amount of cash to be raised by selling securities is not directly
related to the rate of return forgone because the company will want to keep as much
money as possible working and earning a return for as long as possible. Therefore, the
higher the return is on marketable securities, the lower will be the amount in cash that
will be converted from securities at any one time, which is an inverse relationship. When
two things are inversely related, when one increases, the other decreases and vice
versa.
239. Question ID: CMA 1295 1.3 (Topic: Cash and Marketable Securities
Management)
Average daily cash outflows are $3 million for Evans Inc. A new cash management
system can add 2 days to the disbursement schedule. Assuming Evans earns 10% on
excess funds, how much should the firm be willing to pay per year for this cash
management system?

 A. $1,500,000
 B. $600,000correct
 C. $3,000,000
 D. $6,000,000
Question was not answered
Correct Answer Explanation:
In order to answer this question, we need to calculate the additional interest the
company will earn during the year on the additional investable funds. That is the
maximum the firm would be willing to pay. If the firm delays disbursements by 2 days
 Hock P2 2020
Section B - Corporate Finance.
Answers
and its daily cash outflows are $3,000,000 per day, it will have $6,000,000 in additional
investable funds. This will provide $600,000 per year in interest (10% of $6,000,000),
and this is therefore also the maximum amount that the company would be willing to
pay for this service per year.
Explanation for Choice A:
This is one-half of one day's cash disbursements, not the amount the company would
be willing to pay for the new cash management system.
Explanation for Choice C:
This is one day's cash disbursements, not the amount the company would be willing to
pay for the new cash management system.
Explanation for Choice D:
This is the increase in the cash balance that the company will experience from the new
system, not the amount that they would be willing to pay for it.
240. Question ID: CMA 691 1.11 (Topic: Cash and Marketable Securities
Management)
The marketable securities with the least amount of default risk are:

 A. Repurchase agreements.
 B. Federal government agency securities.
 C. Commercial paper.
 D. U.S. treasury securities.correct
Question was not answered
Correct Answer Explanation:
U.S. treasury securities are backed by the federal government as a whole and are
considered to be the investment with the lowest amount of default risk.
Explanation for Choice A:
Repurchase agreements are not considered the marketable security with the least
amount of default risk. If the issuer of the security sold under an agreement to
repurchase it goes bankrupt, the repurchase agreement loses its value.
Explanation for Choice B:
Federal government agency securities are issued by agencies of the federal
government. They are backed only by the agency of the U.S. government that issues
the securities. Therefore, they have slightly more default risk than securities actually
issued by the U.S. government.
Explanation for Choice C:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Commercial paper is not the marketable security with the least amount of default risk.
Commercial paper is unsecured and therefore does not have any collateral behind it.
241. Question ID: ICMA 10.P2.148 (Topic: Cash and Marketable Securities
Management)
Which one of the following instruments would be least appropriate for a corporate
treasurer to utilize for temporary investment of cash?

 A. Municipal bonds.correct
 B. Commercial paper.
 C. Money market mutual funds.
 D. U.S. Treasury bills.
Question was not answered
Correct Answer Explanation:
U.S. Treasury bills, money market mutual funds and commercial paper are all
appropriate for a corporate treasurer to utilize for temporary investment of cash.
However, municipal bonds are long-term bonds. There is a secondary market for them
so they can be sold; but their sale price is subject to changes in their market value.
Therefore, the holder could lose principal if forced to sell a municipal bond to raise cash
for current needs. Thus, municipal bonds are not appropriate for temporary investment
of cash.
Explanation for Choice B:
Commercial paper is appropriate for a corporate treasurer to utilize for temporary
investment of cash. Commercial paper is unsecured promissory notes issued by large
corporations with excellent credit. Commercial paper has short term maturities. Buyers
usually purchase paper with maturities that coincide with their need for the cash and for
that reason, the secondary market for commercial paper is very small, so commercial
paper is not as liquid as some other short-term investments. However, if the holder of
commercial paper needs to liquidate it, the paper can usually be sold back to the issuing
corporation, if it was purchased directly from the issuer, or it can be sold back to the
commercial paper dealer, if it was purchased from a commercial paper dealer.
Explanation for Choice C:
Money market mutual funds are appropriate for a corporate treasurer to utilize for
temporary investment of cash because they are highly liquid, meaning they can be sold
and converted into cash quickly without a significant loss of principal.
Explanation for Choice D:
U.S. Treasury bills are appropriate for a corporate treasurer to utilize for temporary
investment of cash because they are highly liquid, meaning they can be sold and
converted into cash quickly without a significant loss of principal.
 Hock P2 2020
Section B - Corporate Finance.
Answers
242. Question ID: ICMA 10.P2.173 (Topic: Cash and Marketable Securities
Management)
The Texas Corporation is considering the following opportunities to purchase an
investment at the following amounts and discounts.

Term Amount Discount

90 days $80,000 5%
180 days 75,000 6%
270 days 100,000 5%
360 days 60,000 10%
Which opportunity offers the Texas Corporation the highest annual yield?

 A. 90-day investment.correct
 B. 360-day investment.
 C. 180-day investment.
 D. 270-day investment.
Question was not answered
Correct Answer Explanation:
To answer this, we need to calculate the annual yield on each of the options.
90-day investment: $80,000 × 0.05 = $4,000 discount. Cost of investment = $80,000 −
$4,000, or $76,000. Income of $4,000 for a 90 day investment is equal to $16,000
annualized ($4,000 ÷ 90 × 360). $16,000 ÷ $76,000 = 21.05% annualized return on the
investment.
180-day investment: $75,000 × 0.06 = $4,500 discount. Cost of investment = $75,000 −
$4,500, or $70,500. Income of $4,500 for a 180 day investment is equal to $9,000
annualized. $9,000 ÷ $70,500 = 12.77% annualized return.
270-day investment: $100,000 × 0.05 = $5,000 discount. Cost of investment = $100,000
− $5,000, or $95,000. Income of $5,000 for a 270 day investment is equal to $6,667
annualized ($5,000 ÷ 270 × 360). $6,667 ÷ $95,000 = 7.02% annualized return.
360-day investment: $60,000 × 0.10 = $6,000 discount. Cost of investment = $60,000 −
$6,000 or $54,000. Income of $6,000 for 360 days is an annual income so it does not
need to be annualized. $6,000 ÷ $54,000 = 11.11% annual return.
The 90 day investment of $80,000 provides the highest return.
Explanation for Choice B:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This investment does not offer the Texas Corporation the highest annual yield. Please
see the correct answer for a complete explanation.
Explanation for Choice C:
This investment does not offer the Texas Corporation the highest annual yield. Please
see the correct answer for a complete explanation.
Explanation for Choice D:
This investment does not offer the Texas Corporation the highest annual yield. Please
see the correct answer for a complete explanation.
243. Question ID: ICMA 19.P2.082 (Topic: Cash and Marketable Securities
Management)
Money market funds generally invest in all of the following except

 A. bankers’ acceptances.
 B. treasury bonds.correct
 C. certificates of deposit.
 D. commercial paper.
Question was not answered
Correct Answer Explanation:
Money market funds usually invest in only short-term investments. Treasury bonds are
long-term investments with a maturity of 10 to 40 years.
Explanation for Choice A:
Money market funds usually invest in only short-term investments. Bankers’
acceptances are short-term investments that money market funds generally will invest
in.
Explanation for Choice C:
Money market funds usually invest in only short-term investments. Certificates of
deposit are short-term investments that money market funds generally will invest in.
Explanation for Choice D:
Money market funds usually invest in only short-term investments. Commerical paper is
a short-term investment that money market funds generally will invest in.
244. Question ID: CMA 1293 1.20 (Topic: Cash and Marketable Securities
Management)
A lock-box system

 A. Reduces the risk of having checks lost in the mail.

 Hock P2 2020
Section B - Corporate Finance.
Answers
 B. Reduces the need for compensating balances.
 C. Provides security for late night deposits.
 D. Accelerates the inflow of funds.correct
Question was not answered
Correct Answer Explanation:
A lock-box system is used to speed up cash collections by reducing the amount of time
that a check is outstanding after it is mailed by the customer. By having lock-boxes in
various parts of the country, the time the checks spend in the mail is
reduced. Furthermore, the bank receives the checks mailed to the lockbox and
processes them immediately and deposits them to the client's account. The processing
time and the time required before the checks are entered into the clearing process are
both shortened, resulting in collected funds being available sooner to the client.
Explanation for Choice A:
A lock-box system requires that checks be sent through the mail to a specific post office
box. Because it uses the mail system it cannot reduce the risk of a check being lost in
the mail.
Explanation for Choice B:
A lock box is a means of collecting cash from customers and is not related to a
compensating balance.
Explanation for Choice C:
A lock-box system is a manner in which checks are received from customers through
the mail. It does not provide any security for late night deposits.
245. Question ID: CMA 1295 1.8 (Topic: Accounts Receivable Management)
Shown below is a forecast of sales for Cooper Inc. for the first 4 months of the year (all
amounts are in thousands of dollars).

January February March April

Cash sales $15 $24 $18 $14
Sales on credit $100 $120 $90 $70
On average, 50% of credit sales are paid for in the month of sale, 30% in the month
following the sale, and the remainder is paid 2 months after the month of sale.
Assuming there are no bad debts, the expected cash inflow for Cooper in March is:

 A. $122,000
 B. $108,000
 C. $138,000
 Hock P2 2020
Section B - Corporate Finance.
Answers
 D. $119,000correct
Question was not answered
Correct Answer Explanation:
In March, Cooper will receive the $18,000 of cash sales in March, $45,000 (50%) of the
March credit sales of $90,000, $36,000 (30%) of the February credit sales of $120,000
and $20,000 (20%) of the January credit sales of $100,000. This totals $119,000.
Explanation for Choice A:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice B:
This is the $18,000 of cash sales made in March plus 50% of February's credit sales
plus 30% of January's credit sales. The collections from credit sales are 50% of March's
credit sales, 30% of February's credit sales, and 20% of January's credit sales.
Explanation for Choice C:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
246. Question ID: ICMA 10.P2.152 (Topic: Accounts Receivable Management)
Northville Products is changing its credit terms from net 30 to 2/10, net 30.
The least likely effect of this change would be a(n)

 A. increase in short-term borrowings.correct

 B. lower number of days' sales outstanding.
 C. increase in sales.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 D. shortening of the cash conversion cycle.
Question was not answered
Correct Answer Explanation:
An increase in short-term borrowing is the least likely effect of this change in credit
terms. Northville's short-term borrowings will probably decrease, because receivables
will be collected more quickly. Customers will have an incentive to pay within the 10
days to receive a 2% discount.
Explanation for Choice B:
A lower number of days' sales outstanding is not the least likely effect of this change in
credit terms. Receivables will be collected more quickly because customers will have an
incentive to pay within the 10 days to receive a 2% discount. The number of days' sales
outstanding will likely decrease as a result.
Explanation for Choice C:
An increase in sales is not the least likely effect of this change in credit terms. It is
possible that some additional sales would be made to customers who would be
planning to take advantage of the 2% discount by paying within 10 days. Therefore, an
increase in sales could be a likely effect.
Explanation for Choice D:
Shortening of the cash conversion cycle is not the least likely effect of this change in
credit terms. A shorter cash conversion cycle is a likely effect, because receivables will
be collected more quickly. Customers will have an incentive to pay within the 10 days to
receive a 2% discount.
247. Question ID: CMA 1290 1.30 (Topic: Accounts Receivable Management)
Lawson Company has the opportunity to increase annual sales $100,000 by selling to a
new, riskier group of customers. Based on sales, the uncollectible expense is expected
to be 15%, and collection costs will be 5%. The company's manufacturing and selling
expenses are 70% of sales, and its effective tax rate is 40%. If Lawson accepts this
opportunity, the company's after-tax profit will increase by

 A. $9,000.
 B. $10,000.
 C. $6,000.correct
 D. $4,000.
Question was not answered
Correct Answer Explanation:
If the company increases sales by $100,000, they will also increase their manufacturing
and selling expenses by 70% of the amount of sales, or $70,000. This leaves the
 Hock P2 2020
Section B - Corporate Finance.
Answers
company with $30,000 before taking into account the bad debt expense and the
collection costs. The bad debt expense is 15% of the amount of sales and collection
expense is 5%. In total, this will be $20,000 (20% of the $100,000 increase in sales).
This reduces the before tax profit to $10,000. The tax rate is 40%, so after-tax profits
will be only $6,000 if the company increases sales by $100,000 to this riskier group of
customers.
Explanation for Choice A:
This answer does not include the $5,000 of collection costs. See the correct answer for
a complete explanation.
Explanation for Choice B:
This is the before tax increase in profit. The question asks for the after tax increase in
profit. See the correct answer for a complete explanation.
Explanation for Choice D:
This is the amount of the tax expense, not the increase in income. See the correct
answer for a complete explanation.
248. Question ID: ICMA 10.P2.157 (Topic: Accounts Receivable Management)
Computer Services is an established firm that sells computer hardware, software and
services. The firm is considering a change in its credit policy. It has been determined
that such a change would not change the payment patterns of the current customers.
To determine whether such a change would be beneficial, the firm has identified the
proposed new credit terms, the expected additional sales, the expected contribution
margin on the sales, the expected bad debt losses, and the investment in additional
receivables and the period of the investment. What additional information, if any, does
the firm require to determine the profitability of the proposed new policy as compared to
the current credit policy?

 A. The opportunity cost of funds.correct

 B. The credit standards that presently exist.
 C. The new credit standards.
 D. No additional information is needed.
Question was not answered
Correct Answer Explanation:
The company will need to borrow more money because its outstanding receivables
balance as well as its inventory will be higher due to the additional sales expected. The
opportunity cost of funds along with information on the investment that would be
required in increased receivables and inventory will tell the company what its increased
interest cost will be because of needing to carry the increased receivables.
Explanation for Choice B:
 Hock P2 2020
Section B - Corporate Finance.
Answers
The credit standards that presently exist are already known. The question asks
what additional information is needed.
Explanation for Choice C:
The new credit standards are already known. The question asks
what additional information is needed.
Explanation for Choice D:
Some additional information is needed in order to determine the profitability of the
proposed new policy as compared to the current credit policy.
249. Question ID: CMA 1296 1.6 (Topic: Accounts Receivable Management)
A change in credit policy has caused an increase in sales, an increase in discounts
taken, a decrease in the amount of bad debts, and a decrease in the investment in
accounts receivable. Based upon this information, the company's

 A. Average collection period has decreased.correct

 B. Percentage discount offered has decreased.
 C. Working capital has increased.
 D. Accounts receivable turnover has decreased.
Question was not answered
Correct Answer Explanation:
If there is an increase in the number of discounts taken, that means that more
customers are paying early to take advantage of the discount. If there is a decrease in
bad debts, that means that there are fewer old receivables. A decrease in the
investment in accounts receivable coupled with the increase in the credit sales also
indicates that receivables are not outstanding for as long as before. All of these will also
mean that the average collection period has decreased.
Explanation for Choice B:
If more people are taking the discount, that probably means that the amount of the
discount has increased, not decreased.
Explanation for Choice C:
Because cash and receivables are both assets included in working capital, the speed of
the collection of the receivables will not impact the working capital of the company.
Explanation for Choice D:
Given that all of the factors in the question indicate that receivables are being collected
more quickly, they indicate that the accounts receivable turnover has increased, not
decreased.
 Hock P2 2020
Section B - Corporate Finance.
Answers
250. Question ID: ICMA 10.P2.158 (Topic: Accounts Receivable Management)
Harson Products currently has a conservative credit policy and is in the process of
reviewing three other credit policies. The current credit policy (Policy A) results in sales
of $12 million per year. Policies B and C involve higher sales, accounts receivable and
inventory balances, as well as higher bad debt and collection costs. Policy D grants
longer payment terms than Policy C but charges customers interest if they take
advantage of the lengthy payment terms. The policies are outlined below.

P o l i c y (000)
A B C D
Sales $12,000 $13,000 $14,000 $14,000
Average accounts receivable 1,500 2,000 3,500 5,000
Average inventory 2,000 2,300 2,500 2,500
Interest income 0 0 0 500
Bad debt expense 100 125 300 400
Collection cost 100 125 250 350
If the direct cost of products is 80% of sales and the cost of short-term funds is 10%,
what is the optimal policy for Harson?

 A. Policy A.
 B. Policy B.correct
 C. Policy D.
 D. Policy C.
Question was not answered
Correct Answer Explanation:
To answer this question, we calculate the net operating income before tax generated by
each of the four plans. We will calculate the cost of capital to carry the accounts
receivable and inventory first.
To calculate the cost of capital for each of the four proposed plans, we will multiply the
average accounts receivable by 80% (the variable cost of the sales that the company
has invested and needs to finance), add the average inventory to it, and multiply the
total by the cost of capital to calculate the interest expense that will be required to carry
the costs in the average accounts receivable and average inventory for one year.
Plan A: (($1,500 × 0.8) + $2,000) × 0.10 = $320
Plan B: (($2,000 × 0.8) + $2,300) × 0.10 = $390
 Hock P2 2020
Section B - Corporate Finance.
Answers
Plan C: (($3,500 × 0.8) + $2,500) × 0.10 = $530
Plan D: (($5,000 × 0.8) + $2,500) × 0.10 = $650
Net income calculations:
Plan A: ($12,000 × 0.20) − $100 − $100 − $320 + 0 = $1,880 net operating income
before tax.
Plan B: ($13,000 × 0.20) − $125 − $125 − $390 + 0 = $1,960 net operating income
before tax.
Plan C: ($14,000 × 0.20) − $300 − $250 − $530 + 0 = $1,720 net operating income
before tax.
Plan D: ($14,000 × 0.20) − $400 − $350 − $650 + $500 = $1,900 net operating income
before tax.
The plan that will generate the highest net operating income before tax is Plan B.
Explanation for Choice A:
This is not the optimal policy for Harson, because it does not result in the highest net
operating income before taxes.
Explanation for Choice C:
This is not the optimal policy for Harson, because it does not result in the highest net
operating income before taxes.
Explanation for Choice D:
This is not the optimal policy for Harson, because it does not result in the highest net
operating income before taxes.
251. Question ID: ICMA 19.P2.083 (Topic: Accounts Receivable Management)
A company offers all customers trade credit terms of 2/15, net 60. Currently, 30% of
sales receipts are paid with the discount applied. If the company were to change its
credit terms, a change to which one of the following terms is most likely to cause the
company’s average collection period to decrease?

 A. 1/15, net 90.

 B. 1/15, net 60.
 C. 2/15, net 30.correct
 D. 1/15, net 30.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
The company's average collection period will decrease when there is more benefit to
the customer of paying early. Decreasing the period of time to receive the discount will
decrease the average collection period.
Explanation for Choice A:
The company's average collection period will decrease when there is more benefit to
the customer of paying early. Decreasing the amount of the discount and extending the
time period of the discount will encourage slower payment by customers.
Explanation for Choice B:
The company's average collection period will decrease when there is more benefit to
the customer of paying early. Decreasing the amount of the discount will encourage
slower payment by customers.
Explanation for Choice D:
The company's average collection period will decrease when there is more benefit to
the customer of paying early. Decreasing the amount of the discount will encourage
slower payment by customers.
252. Question ID: ICMA 10.P2.154 (Topic: Accounts Receivable Management)
A credit manager considering whether to grant trade credit to a new customer
is most likely to place primary emphasis on

 A. valuation ratios.
 B. growth ratios.
 C. profitability ratios.
 D. liquidity ratios.correct
Question was not answered
Correct Answer Explanation:
Trade credit is short-term credit (less than one year to maturity). A borrower’s ability to
repay short-term credit is determined by its liquidity, or whether it has enough in current
assets to be able to cover its current liabilities. Therefore, a credit manager considering
whether to grant trade credit to a new customer is most likely to place primary emphasis
on the company's liquidity ratios.
Explanation for Choice A:
Trade credit is short-term credit (less than one year to maturity). A borrower’s ability to
repay short-term credit is determined by its liquidity, or whether it has enough in current
assets to be able to cover its current liabilities. Therefore, a credit manager considering
whether to grant trade credit to a new customer is not likely to place primary emphasis
on valuation ratios. Valuation ratios are important to investors who are considering
investing in a company.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice B:
Trade credit is short-term credit (less than one year to maturity). A borrower’s ability to
repay short-term credit is determined by its liquidity, or whether it has enough in current
assets to be able to cover its current liabilities. Therefore, a credit manager considering
whether to grant trade credit to a new customer is not likely to place primary emphasis
on growth ratios. Growth ratios, or growth rates, are used to determine how fast a
company is growing. Growth ratios are important to investors who are considering
investing in a company.
Growth ratios are generally stated in terms of the percentage of growth from the prior
year, i.e., "sales revenue increased by 25% over last year." Sales growth is important
because it indicates an increasing market for the firm's products and services. Growth
in net income is even more important than sales growth, because net income tells the
investor how much money is left over after all the operating costs are subtracted from
sales revenue. Growth in dividends is used by investors as an indicator of the financial
health of a company.
Explanation for Choice C:
Trade credit is short-term credit (less than one year to maturity). A borrower’s ability to
repay short-term credit is determined by its liquidity, or whether it has enough in current
assets to be able to cover its current liabilities. Therefore, a credit manager considering
whether to grant trade credit to a new customer is not likely to place primary emphasis
on profitability ratios. Profitability ratios are important when a lender is considering long-
term credit (longer than one year).
253. Question ID: ICMA 10.P2.155 (Topic: Accounts Receivable Management)
Foster Products is reviewing its trade credit policy with respect to the small retailers to
which it sells. Four plans have been studied and the results are as follows.

Annual Bad Collection Accounts

Plan Revenue Debt Costs Receivable Inventory
A $200,000 $ 1,000 $1,000 $20,000 $40,000
B 250,000 3,000 2,000 40,000 50,000
C 300,000 6,000 5,000 60,000 60,000
D 350,000 12,000 8,000 80,000 70,000
The information shows how various annual expenses such as bad debts and the cost of
collections change as sales change. The average balance of accounts receivable and
inventory have also been projected. The cost of the product to Foster is 80% of the
selling price, after-tax cost of capital is 15%, and Foster's effective income tax rate is
30%. What is the optimal plan for Foster to implement?

 A. Plan A.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 B. Plan B.correct
 C. Plan D.
 D. Plan C.
Question was not answered
Correct Answer Explanation:
To answer this question, we calculate the net income after tax generated by each of the
four plans. We will include the cost of capital to carry the accounts receivable and
inventory last, after we have calculated the Operating Income After Tax, since the cost
of capital given in the problem is an after-tax cost.
To calculate the cost of capital for each of the four proposed plans, we will multiply the
average accounts receivable by 80% (the variable cost of the sales that the company
has invested and needs to finance), add the average inventory to it, and multiply the
total by the after-tax cost of capital to calculate the after-tax interest expense that will be
required to carry the costs in the average accounts receivable and average inventory for
one year.
Plan A: (($20,000 × 0.8) + $40,000) × 0.15 = $8,400
Plan B: (($40,000 × 0.8) + $50,000) × 0.15 = $12,300
Plan C: (($60,000 × 0.8) + $60,000) × 0.15 = $16,200
Plan D: (($80,000 × 0.8) + $70,000) × 0.15 = $20,100
Net income calculations:
Plan A: ($200,000 × 0.20) − $1,000 − $1,000 = $38,000 net operating income before
tax.
Net operating income after tax = $38,000 × 0.70 = $26,600.
$26,000 − $8,400 after-tax cost of capital = net income of $18,200.
Plan B: ($250,000 × 0.20) − $3,000 − $2,000 = $45,000 net operating income before
tax.
Net operating income after tax = $45,000 × 0.70 = $31,500.
$31,500 − $12,300 after-tax cost of capital = net income of $19,200.
Plan C: ($300,000 × 0.20) − $6,000 − $5,000 = $49,000 net operating income before
tax.
Net operating income after tax = $49,000 × 0.070 = $34,300.
$34,300 − $16,200 after-tax cost of capital = net income of $18,100.
Plan D: ($350,000 × 0.20) − $12,000 − $8,000 = $50,000 net operating income before
tax.
Net operating income after tax = $50,000 × 0.70 = $35,000.
$35,000 − $20,100 after-tax cost of capital = net income of $14,900.
The plan that will generate the highest net income is Plan B.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice A:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice C:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
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Explanation for Choice D:
One way to arrive at this incorrect answer would be to use the cost of capital as a
before-tax cost. The problem says that the 15% cost of capital is after tax. Please see
the correct answer for a complete explanation.
254. Question ID: CMA 697 1.14 (Topic: Accounts Receivable Management)
The sales manager at Ryan Company feels confident that, if the credit policy at Ryan's
were changed, sales would increase and, consequently, the company would utilize
excess capacity. The two credit proposals being considered are as follows:

Proposal A Proposal B
Increase in sales $500,000 $600,000
Contribution margin 20% 20%
Bad debt percentage 5% 5%
Increase in operating profits $75,000 $90,000
Desired return on sales 15% 15%
Currently, payment terms are net 30. The proposed payment terms for Proposal A and
Proposal B are net 45 and net 90, respectively. An analysis to compare these two
 Hock P2 2020
Section B - Corporate Finance.
Answers
proposals for the change in credit policy would include all of the following factors except
the

 A. Current bad debt experience.correct

 B. Cost of funds for Ryan.
 C. Impact on the current customer base of extending terms to only certain customers.
 D. Bank loan covenants on days' sales outstanding.
Question was not answered
Correct Answer Explanation:
The current levels of bad debts will not impact the decision about which of these two
options is better. If the level of bad debts is expected to change as a result of the
decision they make, the amount of change only would impact the decision. But the
current level of bad debts is irrelevant to the decision.
Explanation for Choice B:
Because the proposals will increase credit sales while extending payment terms, the
company's accounts receivable balance will increase with either of the proposals. The
increase in receivables is like an investment made, and it will require financing to bridge
the short-term gap in cash flows. The cost of funds is an important part of this decision.
Explanation for Choice C:
If terms will be extended to only certain customers, this is something that the company
needs to take into account because the reaction of customers may change the results of
the plans significantly.
Explanation for Choice D:
Because the proposals will increase credit sales while extending payment terms, the
company's accounts receivable balance will increase with either of the proposals.
Extending payment terms will probably cause the days' sales outstanding to increase.
This is something that must be considered because it is possible that if it takes the
company too long to collect their receivables, they will violate the covenants on their
bank loans and be in technical default.
255. Question ID: ICMA 10.P2.153 (Topic: Accounts Receivable Management)
Snug-fit, a maker of bowling gloves, is investigating the possibility of liberalizing its
credit policy. Currently, payment is made on a cash-on-delivery basis. Under a new
program, sales would increase by $80,000. The company has a gross profit margin of
40%. The estimated bad debt loss rate on the incremental sales would be 6%. Ignoring
the cost of money, what would be the return on sales before taxes for the new sales?

 A. 36.2%.
 B. 40.0%.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 C. 42.5%.
 D. 34.0%.correct
Question was not answered
Correct Answer Explanation:
The gross profit on the additional sales will be 40% of $80,000, or $32,000. Bad debt
loss on the additional sales will be 6% of $80,000, or $4,800. Therefore, the before-tax
profit on the additional sales will be $32,000 minus $4,800, or $27,200. $27,200 is 34%
of $80,000 ($27,200 ÷ $80,000 = 0.34).
Explanation for Choice A:
This answer results from subtracting the bad debt expense from both the numerator and
the denominator of the return on sales ratio. The bad debt expense should be
subtracted from the numerator but not from the denominator.
Explanation for Choice B:
This answer omits the cost of the expected bad debt loss on the additional sales.
Explanation for Choice C:
This answer results from subtracting the expected bad debt loss from the additional
sales amount before calculating the return on sales. Instead, the expected bad debt loss
should be subtracted from the expected gross profit on the additional sales.
256. Question ID: CMA 1292 1.21 (Topic: Accounts Receivable Management)
Dartmoor Company's budgeted sales for the coming year are $40,500,000, of which
80% are expected to be credit sales at terms of n/30. Dartmoor estimates that a
proposed relaxation of credit standards will increase credit sales by 20% and increase
the average collection period from 30 days to 40 days. Based on a 360-day year, the
proposed relaxation of credit standards will result in an expected increase in the
average accounts receivable balance of

 A. $1,620,000.correct
 B. $2,700,000.
 C. $540,000.
 D. $900,000.
Question was not answered
Correct Answer Explanation:
The question does not say that total sales will increase as a result of the relaxation of
credit standards, only that credit sales will increase. Therefore, we assume that total
sales will remain the same if the credit standards are relaxed but that credit sales will
increase to 96% of total sales, from the 80% budgeted. (0.80 × 1.20 = 0.96)
 Hock P2 2020
Section B - Corporate Finance.
Answers
Since the question asks how much the average accounts receivable balance would
increase, we need to calculate the average balance of accounts receivable under the
existing terms, then the average balance under the proposed terms, and then calculate
the difference.
Annual credit sales ÷ 360 = credit sales per day. Credit sales per day × number of days
in receivables = average balance of accounts receivable.
Total sales are budgeted at $40,500,000, and 80% of sales is $32,400,000 in total credit
sales, while 96% of sales is $38,880,000 in total credit sales.
Existing terms: $32,400,000 ÷ 360 × 30 days = $2,700,000.
Proposed terms: $38,880,000 ÷ 360 × 40 days = $4,320,000.
Difference = $4,320,000 − $2,700,000 = $1,620,000.
Explanation for Choice B:
This is the average receivables balance under the existing policy. See the correct
answer for a complete explanation.
Explanation for Choice C:
This answer incorrectly uses 30 days of sales outstanding under the new policy as well
as under the old policy. See the correct answer for a complete explanation.
Explanation for Choice D:
This answer does not take into account the increase in credit sales that is expected to
occur if the policy is changed.
257. Question ID: ICMA 10.P2.142 (Topic: Accounts Receivable Management)
Powell Industries deals with customers throughout the country and is attempting to
more efficiently collect its accounts receivable. A major bank has offered to develop and
operate a lock-box system for Powell at a cost of $90,000 per year. Powell averages
300 receipts per day at an average of $2,500 each. Its short-term interest cost is 8%
per year. Using a 360-day year, what reduction in average collection time would be
needed in order to justify the lock-box system?

 A. 1.20 days.
 B. 1.50 days.correct
 C. 1.25 days.
 D. 0.67 days.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
When a company has lockbox service, the service speeds up the receipt and deposit of
its receivables. The amount received during the initial number of days that the receipts
are speeded up can be seen as a permanent amount that the company can invest and
earn interest on. Or, in this case, the company can pay down its short-term loans and
save the interest it would have paid on the amount of the paydown.
So if receivables are speeded up by 2 days for example, the "extra" amount received
during those first two days that they have the service can be invested permanently, and
the company can continue earning interest on it.
So we need to find out by how many days receipts need to be speeded up in order to
earn interest of $90,000 per year, because that is what the lockbox service will cost the
company.
The company has 300 receipts per day that average $2,500 each. Therefore, the
average amount received per day is $750,000.
The equation that will equate the amount received in interest with the amount paid in
lockbox fees is:
750,000D × 0.08 = 90,000
D represents the number of days the receipts will be speeded up. The number of days
the receipts will be speeded up multiplied by $750,000 and then multiplied by 0.08
equals the amount of interest the company can earn on the speeded-up receipts.
Solving for D:
Multiply 750,000 by 0.08:
60,000D = 90,000
Divide both sides of the equation by 60,000 to isolate the D:
D = 1.5 days
Explanation for Choice A:
This is not the correct answer. Please see the correct answer for an explanation.
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materials better.
Explanation for Choice C:
This is not the correct answer. Please see the correct answer for an explanation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
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Explanation for Choice D:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
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incorrect answer choice -- not its letter, because that can change with every study
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in advance for helping us to make your HOCK study materials better.
258. Question ID: CMA 1292 1.19 (Topic: Accounts Receivable Management)
Price Publishing is considering a change in its credit terms from n/30 to 2/10, n/30. The
company's budgeted sales for the coming year are $24,000,000, of which 90% are
expected to be made on credit. If the new credit terms are adopted, Price estimates that
discounts will be taken on 50% of the credit sales; however, uncollectible accounts will
be unchanged. The new credit terms will result in expected discounts taken in the
coming year of

 A. $240,000.
 B. $216,000.correct
 C. $432,000.
 D. $480,000.
Question was not answered
Correct Answer Explanation:
Of the $24,000,000 of sales, 90% are expected to be credit sales. This is $21,600,000
of expected credit sales. They expect that one-half of the customers will take the
discount. Half of the customers is $10,800,000 and the discount is 2%. 2% of the
receivables for which the discount will be used is $216,000.
Explanation for Choice A:
This is what the discount would be if it were applied to one-half of all the sales. The
discount would be applied only to one-half of the credit sales. See the correct answer
for a complete explanation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice C:
This is what the discount would be if it were applied to all of the credit sales. See the
correct answer for a complete explanation.
Explanation for Choice D:
This is what the discount would be if it were applied to all of the sales. See the correct
answer for a complete explanation.
259. Question ID: ICMA 10.P2.151 (Topic: Accounts Receivable Management)
Clauson Inc. grants credit terms of 1/15, net 30 and projects gross sales for the year of
$2,000,000. The credit manager estimates that 40% of customers pay on the 15th day,
40% of the 30th day and 20% on the 45th day. Assuming uniform sales and a 360-day
year, what is the projected amount of overdue receivables?

 A. $400,000
 B. $50,000correct
 C. $83,333
 D. $116,676
Question was not answered
Correct Answer Explanation:
The process to calculate the answer to this question is as follows:
(1) Determine the average sales per day. The company projects gross sales to be
$2,000,000 for the year. Based on a 360-day year, that is $5,555.55 in average sales
per day ($2,000,000 ÷ 360).
(2) Determine the number of days' sales in accounts receivable that will be overdue at
any given time. 20% of the sales will be paid on the 45th day, which is past the due date
of 30 days, so those receivables will be overdue. 0.20 × 45 = 9 days, so there will be 9
days' sales in accounts receivable at any given time that will be past due.
(3) The accounts receivable balance outstanding that is projected to be overdue at any
given time is the average sales per day of $5,555.55 multiplied by 9 days' sales that are
overdue. $5,555.55 × 9 = $50,000.
If step (2) does not seem to make sense, here is the reason we do that: If we needed to,
we could calculate the total number of days' sales in accounts receivable by using a
weighted average, which is the sum of each number of days to pay given in the
problem, multiplied by each percentage of the total, as follows:

0.40 × 15 days' sales outstanding = 6 days

0.40 × 30 days' sales outstanding = 12 days
 Hock P2 2020
Section B - Corporate Finance.
Answers
0.20 × 45 days' sales outstanding = 9 days
Total number of days' sales outstanding in accounts receivable 27 days
The total number of days' sales outstanding in accounts receivable will be 27 days.
From that, we can calculate the total outstanding balance of all the accounts by
multiplying 27 days by the daily average sales amount of $5,555.55. The result is
$150,000, and that will be the projected total accounts receivable on any given date and
also the projected average balance of accounts receivable.
It is not necessary to calculate the total number of days' sales outstanding in accounts
receivable or the total average balance in accounts receivable to answer this question,
but it does help to see the reasoning behind step (2) above.
Of the $150,000 average balance in accounts receivable, which is 27 days worth of
sales, 9 days worth of sales, or 9 × $5,555.55, which is $50,000, will be paid on the 45th
day and thus will be past due at any given time.
Explanation for Choice A:
This is 20% of the total projected annual sales. However, not all of the annual sales will
be outstanding as receivables at any one time. The question is asking how much of the
amount of receivables outstanding at any one time will be past due.
Explanation for Choice C:
This is 15 days worth of sales, which is the difference between the 45 days taken by
20% of the customers and the 30 days allowed. However, the correct way to solve this
is to calculate how many days worth of sales that are outstanding in accounts
receivable at any given time will be 45 days old. That number of days multiplied by the
average daily sales amount will be the projected amount of overdue receivables. See
correct answer for an explanation of how to do this.
Explanation for Choice D:
This is 21 days worth of sales. However, the correct way to solve this is to calculate how
many days worth of sales that are outstanding in accounts receivable at any given time
will be 45 days old. That number of days multiplied by the average daily sales amount
will be the projected amount of overdue receivables. See correct answer for an
explanation of how to do this.
260. Question ID: CMA 1292 1.20 (Topic: Accounts Receivable Management)
Best Computers believes that its collection costs could be reduced through modification
of collection procedures. This action is expected to result in a lengthening of the
average collection period from 28 days to 34 days; however, there will be no change in
uncollectible accounts. The company's budgeted credit sales for the coming year are
$27,000,000, and short-term interest rates are expected to average 8%. To make the
changes in collection procedures cost beneficial, the minimum savings in collection
costs (using a 360-day year) for the coming year would have to be
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. $360,000.
 B. $180,000.
 C. $30,000.
 D. $36,000.correct
Question was not answered
Correct Answer Explanation:
If Best changes its credit terms, it will have an extra 6 days of sales outstanding
throughout the year (34 − 28). Since credit sales are budgeted at $27,000,000 and the
company uses a 360-day year, this equals $75,000 in average credit sales per day and
$450,000 in credit sales for 6 days ($27,000,000 ÷ 360 × 6). Because the company will
be holding this as additional receivables, it will not be able to invest this money
elsewhere, thereby losing 8%, or $36,000 in interest during the year because of the
higher receivables balance and the increased money "invested" in receivables.
Therefore, Best must be able to save at least $36,000 in collection costs in order to
make this change beneficial to the company.
Explanation for Choice A:
This is interest for two months on $27,000,000 at 8% annual interest. The outstanding
balance of receivables will increase because of the lengthening of the average
collection period and there will be an opportunity cost equal to the interest lost on the
amount of the increase. However, the average increase in receivables over the course
of the year will not be $27,000,000. That figure is the total budgeted credit sales. The
opportunity cost of interest on the increase in receivables will be equal to only the
amount of increase in the outstanding receivables balance caused by the increased
collection period multiplied by 8%, and it will be for a full year's time, not two month's
time.
Explanation for Choice B:
This is interest for one month on $27,000,000 at 8% annual interest. The outstanding
balance of receivables will increase because of the lengthening of the average
collection period and there will be an opportunity cost equal to the interest lost on the
amount of the increase. However, the average increase in receivables over the course
of the year will not be $27,000,000. That figure is the total budgeted credit sales. The
opportunity cost of interest on the increase in receivables will be equal to only the
amount of increase in the outstanding receivables balance caused by the increased
collection period multiplied by 8%, and it will be for a full year's time, not one month's
time.
Explanation for Choice C:
This is not the correct answer. Please see the correct answer for a complete
explanation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
261. Question ID: CMA 1295 1.6 (Topic: Accounts Receivable Management)
Jackson Distributors sells to retail stores on credit terms of 2/10, net 30. Daily sales
average 150 units at a price of $300 each. Assuming that all sales are on credit and
60% of customers take the discount and pay on day 10 while the rest of the customers
pay on day 30, the amount of Jackson's accounts receivable is

 A. $810,000correct
 B. $900,000
 C. $1,350,000
 D. $990,000
Question was not answered
Correct Answer Explanation:
If Jackson Distributors sells 150 units at $300 each day, they will have daily sales of
$45,000. In a 30 day period, this is total sales of $1,350,000. In order to answer this
question, what we can do is look at one typical month and see what the receivables will
be at the end of the month. In the first 20 days of the month there were sales of
$900,000 and of this amount only 60% has been paid by the end of the month.
Therefore, there is still 40%, or $360,000 remaining as a receivable. Of the sales made
after the 20th of the month ($450,000), none has yet been collected. So, the receivables
balance at the end of the 30 days is $810,000 ($360,000 + $450,000).
This can also be solved by calculating the number of days of sales the company has in
receivables at any one time and multiplying that number of days by the company's daily
sales of $45,000.
Calculate the weighted average of the number of days that customers take to pay:
(0.60 × 10) + (0.40 × 30) = 18 days
18 days × $45,000 = $810,000
Explanation for Choice B:
This answer results from using the average of the 10-day collection period and the 30
day collection period — 20 days — and multiplying that average by the daily sales
volume of $45,000 (150 units at a price of $300 each). The average of the two collection
 Hock P2 2020
Section B - Corporate Finance.
Answers
periods should be a weighted average, weighted according to each one's percentage of
the total payments, not a simple average.
Explanation for Choice C:
This is the amount of sales for the month, not the receivables balance at the end of the
month. See the correct answer for a complete explanation.
Explanation for Choice D:
This answer results from calculating a weighted average of the number of days that
customers take to pay, then multiplying the calculated weighted average by the daily
sales volume of $45,000 (150 units at a price of $300 each). The only error in this
calculation is that the percentages of the total payments represented in each of the two
collection periods is reversed in the weighted average collection period calculation.
262. Question ID: CMA 1294 1.22 (Topic: Accounts Receivable Management)
A firm averages $4,000 in sales per day and is paid, on an average, within 30 days of
the sale. After they receive their invoice, 55% of the customers pay by check, while the
remaining 45% pay by credit card. Approximately how much would the company show
in accounts receivable on its balance sheet on any given date?

 A. $4,000
 B. $54,000
 C. $120,000correct
 D. $48,000
Question was not answered
Correct Answer Explanation:
Since they have $4,000 of sales per day and it takes on average 30 days to collect the
cash, at any one time the company should have approximately $120,000 of receivables
on the balance sheet ($4,000 × 30). The information about checks and credit cards is
irrelevant, because a receivable is paid whether it is paid by check or by credit card. All
we need to know is how long on average it takes to collect the receivables.
Explanation for Choice A:
This is the amount of receivables from one day of sales. At any one time the receivables
from 30 days are outstanding. See the correct answer for a complete explanation.
Explanation for Choice B:
This is one day's worth of sales ($4,000) multiplied by 30 days average collection time,
multiplied by the 45% of receivables that are paid by credit card. The information about
checks and credit cards is irrelevant, because a receivable is paid whether it is paid by
check or by credit card.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice D:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
263. Question ID: CMA 691 1.7 (Topic: Accounts Receivable Management)
An organization would usually offer credit terms of 2/10, net 30 when

 A. The organization can borrow funds at a rate less than the annual interest cost.
 B. The cost of capital approaches the prime rate.
 C. The organization can borrow funds at a rate exceeding the annual interest cost.
 D. Most competitors are offering the same terms, and the organization has a shortage of
cash.correct
Question was not answered
Correct Answer Explanation:
Cash discounts should be offered only if competitors are offering them and thus
customers expect such a discount or if the seller needs cash and is not able to borrow it
elsewhere at a lower rate.
Explanation for Choice A:
If the company could borrow money at a rate lower than the rate related to the cash
discount, they should borrow the money and not offer the cash discount.
Explanation for Choice B:
Whether or not the cost of capital is close to the prime rate is not a determinant of
whether the company should offer the cash discount. The cash discount should be
offered if the seller needs cash, the effective interest rate of offering the discount is
lower than to borrow funds, or it needs to be offered in order to remain competitive
within the market.
Explanation for Choice C:
Just because the cost to borrow is higher than the effective rate of the cash discount
does not mean that the company should offer the cash discount. The cash discount
should be offered only if there is a need for cash in the short-term as well or if a
discount needs to be offered in order to remain competitive within the market..
 Hock P2 2020
Section B - Corporate Finance.
Answers
264. Question ID: ICMA 13.P2.030 (Topic: Accounts Receivable Management)
The Philadelphia Corporation has been advised by their accountant, Phyllis Brown, that
the following four sales volumes could be achieved along with the following receivable
payment patterns and bad debts, depending on the company's credit policy (in
thousands).

Sales 30 60 90 120 Bad

Volume Days Days Days Days Debts
I. $520 $300 $100 $100 $0 $ 20
II. 630 200 200 100 100 30
III. 770 200 100 200 200 70
IV. 900 100 200 200 300 100
Assuming that the firm's cost of capital is 20% and that all payments are made on the
first possible day of the aging month, which sales volume will maximize profit?

 A. III.
 B. II.
 C. I.
 D. IV.correct
Question was not answered
Correct Answer Explanation:
The only information we have with which to answer this question is the cost of the bad
debts and information to calculate the interest cost of carrying the accounts receivable.
Other information such as cost of goods sold is not given, and since that will be the
same under all of the options, it is not relevant and thus not needed. So we will
calculate the cost of interest at 20% under each of the options and subtract the interest
cost and the bad debt amount from each option's revenue to find the option with the
highest profit.

Option Option Option Option

I II III IV
Sales
$520 $630 $770 $900
revenue
Bad debts 20 30 70 100

30 days: amount received × 0.20 ÷ 360

Interest: $ 5 $ 3 $ 3 $ 2
× 30
 Hock P2 2020
Section B - Corporate Finance.
Answers
60 days: amount received × 0.20 ÷ 360
3 7 3 7
× 60
90 days: amount received × 0.20 ÷ 360
5 3 10 10
× 90
120 days: amount received × 0.20 ÷ 360
0 7 13 20
× 120
Total interest cost $ 13 $ 20 $ 29 $ 39

Net Profit (Revenue − Bad Debts − Total Interest) $487 $580 $671 $761
The highest net profit of the four options is with Option IV.
Explanation for Choice A:
This is not the most profitable option. To calculate the most profitable option, calculate
the cost of interest at 20% under each of the options and subtract the interest and the
bad debt amount from each revenue amount to find the option with the highest "profit."
Explanation for Choice B:
This is not the most profitable option. To calculate the most profitable option, calculate
the cost of interest at 20% under each of the options and subtract the interest and the
bad debt amount from each revenue amount to find the option with the highest "profit."
Explanation for Choice C:
This is not the most profitable option. To calculate the most profitable option, calculate
the cost of interest at 20% under each of the options and subtract the interest and the
bad debt amount from each revenue amount to find the option with the highest "profit."
265. Question ID: CMA 1294 1.24 (Topic: Accounts Receivable Management)
A company plans to tighten its credit policy. The new policy will decrease the average
number of days in collection from 75 to 50 days and will reduce the ratio of credit sales
to total revenue from 70% to 60%. The company estimates that projected sales will be
5% less if the proposed new credit policy is implemented. If projected sales for the
coming year are $50 million, calculate the dollar impact on accounts receivable of this
proposed change in credit policy. Assume a 360-day year.

 A. $3,333,300 decrease.correct
 B. $3,819,445 decrease.
 C. $6,500,000 decrease.
 D. $18,749,778 increase.
Question was not answered
 Hock P2 2020
Section B - Corporate Finance.
Answers
Correct Answer Explanation:
This question is most easily solved by setting up a calculation of the receivable balance
under both the existing policy and the proposed policy. This is done below:

Existing Proposed
Policy Policy
Total Sales $50,000,000 $47,500,000
Credit Sales $35,000,000 $28,500,000
Credit Sales Per Day (Credit Sales ÷ 360) $97,222 $79,167
No. of Days A/R Outstanding 75 50
Average A/R Outstanding
(Credit Sales Per day × # Days A/R Outst) $7,291,650 $3,958,350
The difference between these two amounts is the amount by which accounts receivable
will change. The difference is $3,333,300.
Explanation for Choice B:
This answer uses total sales to calculate the ending balance of receivables. Credit sales
should be used instead. See the correct answer for a complete explanation.
Explanation for Choice C:
This is the decrease in credit sales that will result from this change in policy. See the
correct answer for a complete explanation.
Explanation for Choice D:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
266. Question ID: ICMA 10.P2.156 (Topic: Accounts Receivable Management)
Consider the following factors affecting a company as it is reviewing its trade credit
policy.

I. Operating at full capacity.

 Hock P2 2020
Section B - Corporate Finance.
Answers
II. Low cost of borrowing.
III. Opportunity for repeat sales.
IV. Low gross margin per unit.
Which of the above factors would indicate that the company should liberalize its credit
policy?

 A. II and III only.correct

 B. III and IV only.
 C. I and II only.
 D. I, II and III only.
Question was not answered
Correct Answer Explanation:
II and III are factors that would indicate the company should liberalize its credit policy.
When a firm liberalizes its credit policy, it lowers its requirements for extending credit.
That means more of its customers will qualify for credit. As a result, its sales will
increase, and its outstanding receivables will also increase. Its uncollectible accounts
will also increase. The firm would probably also need to increase its own short-term
borrowing to support increases in accounts receivable and also inventory that would be
required.
It would make sense for the firm to liberalize its credit policy only if (a) the costs of doing
so were lower than the increased profit that would result from increased sales and (b) if
it were able to fulfill the increased demand that would result.
If the firm’s cost of borrowing is low (II), this would increase the possibility that the costs
of liberalizing its credit policy would be lower than the increased profits that would be
obtained because of increased sales. So II is a factor that would indicate the company
should liberalize its credit policy.
If liberalizing its credit policy were to create opportunities for repeat sales (III), this would
increase profits because of the increased sales. Because the increased sales would be
coming from repeat customers, those sales would not require the company to incur the
expenses of gaining a new customer and doing the necessary credit investigation.
Therefore, sales from existing customers should be more profitable than sales to new
customers. If those sales generated more profit than the increased costs associated
with liberalizing its credit policy, liberalizing the credit policy would be a good decision.
So III is a factor that would indicate the company should liberalize its credit policy.
Explanation for Choice B:
Of these two factors, only III would be a factor that would indicate the company should
liberalize its credit policy.
 Hock P2 2020
Section B - Corporate Finance.
Answers
When a firm liberalizes its credit policy, it lowers its requirements for extending credit.
That means more of its customers will qualify for credit. As a result, its sales will
increase, and its outstanding receivables will also increase. Its uncollectible accounts
will also increase. The firm would probably also need to increase its own short-term
borrowing to support increases in accounts receivable and also inventory that would be
required.
It would make sense for the firm to liberalize its credit policy only if (a) the costs of doing
so were lower than the increased profit that would result from increased sales and (b) if
it was able to fulfill the increased demand that would result.
If liberalizing its credit policy were to create opportunities for repeat sales (III), this would
increase profits because of the increased sales. Because the increased sales would be
coming from repeat customers, those sales would not require the company to incur the
expenses of gaining a new customer and doing the necessary credit investigation.
Therefore, sales from existing customers should be more profitable than sales to new
customers. If those sales generated more profit than the increased costs associated
with liberalizing its credit policy, liberalizing the credit policy would be a good decision.
So III is a factor that would indicate the company should liberalize its credit policy.
A low gross margin per unit (IV) would indicate that the increased profits from increasing
sales would not be very great. Therefore, there is a greater possibility that the increased
costs associated with liberalizing its credit policy would be greater than the increased
profits that would result. So IV is not a factor that would indicate the company should
liberalize its credit policy.
Explanation for Choice C:
Of these two factors, only II would be a factor that would indicate the company should
liberalize its credit policy.
When a firm liberalizes its credit policy, it lowers its requirements for extending credit.
That means more of its customers will qualify for credit. As a result, its sales will
increase, and its outstanding receivables will also increase. Its uncollectible accounts
will also increase. The firm would probably also need to increase its own short-term
borrowing to support increases in accounts receivable and also inventory that would be
required.
It would make sense for the firm to liberalize its credit policy only if (a) the costs of doing
so were lower than the increased profit that would result from increased sales and (b) if
it was able to fulfill the increased demand that would result.
If the firm is already operating at full capacity (I), it would not be able to supply any more
product. Therefore, it would not want orders to increase, because it would not be able to
fulfill them. So I is not a factor that would indicate the company should liberalize its
credit policy.
 Hock P2 2020
Section B - Corporate Finance.
Answers
If the firm’s cost of borrowing is low (II), this would increase the possibility that the costs
of liberalizing its credit policy would be lower than the increased profits that would be
obtained because of increased sales. So II is a factor that would indicate the company
should liberalize its credit policy.
Explanation for Choice D:
Of these three factors, only II and III would be factors that would indicate the company
should liberalize its credit policy.
When a firm liberalizes its credit policy, it lowers its requirements for extending credit.
That means more of its customers will qualify for credit. As a result, its sales will
increase, and its outstanding receivables will also increase. Its uncollectible accounts
will also increase. The firm would probably also need to increase its own short-term
borrowing to support increases in accounts receivable and also inventory that would be
required.
It would make sense for the firm to liberalize its credit policy only if (a) the costs of doing
so were lower than the increased profit that would result from increased sales and (b) if
it was able to fulfill the increased demand that would result.
If the firm is already operating at full capacity (I), it would not be able to supply any more
product. Therefore, it would not want orders to increase, because it would not be able to
fulfill them. So I is not a factor that would indicate the company should liberalize its
credit policy.
If the firm’s cost of borrowing is low (II), this would increase the possibility that the costs
of liberalizing its credit policy would be lower than the increased profits that would be
obtained because of increased sales. So II is a factor that would indicate the company
should liberalize its credit policy.
If liberalizing its credit policy were to create opportunities for repeat sales (III), this would
increase profits because of the increased sales. Because the increased sales would be
coming from repeat customers, those sales would not require the company to incur the
expenses of gaining a new customer and doing the necessary credit investigation.
Therefore, sales from existing customers should be more profitable than sales to new
customers. If those sales generated more profit than the increased costs associated
with liberalizing its credit policy, liberalizing the credit policy would be a good decision.
So III is a factor that would indicate the company should liberalize its credit policy.
267. Question ID: CMA 1295 1.4 (Topic: Accounts Receivable Management)
The average collection period for a firm measures the number of days

 A. beyond the end of the credit period before a typical customer payment is received.
 B. for a typical check to "clear" through the banking system.
 C. after a typical credit sale is made until the firm receives the payment.correct
 D. before a typical account becomes delinquent.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Question was not answered
Correct Answer Explanation:
The average collection period is the average number of days that it takes the company
to collect the cash from a credit sale.
Explanation for Choice A:
A "typical" customer payment is not received beyond the end of the credit period. Only
delinquent payments are received beyond the end of the credit period.
Explanation for Choice B:
This is the concept of float in the check clearance process, not the average collection
period.
Explanation for Choice D:
The time period before an account becomes delinquent is the period in which the
customer has to pay; and "typical" accounts do not become delinquent. See the correct
answer for a complete explanation.
268. Question ID: CMA 1290 1.22 (Topic: Accounts Receivable Management)
An aging of accounts receivable measures the

 A. Amount of receivables that have been outstanding for given lengths of time.correct
 B. Average length of time that receivables have been outstanding.
 C. Ability of the firm to meet short-term obligations.
 D. Percentage of sales that have been collected after a given time period.
Question was not answered
Correct Answer Explanation:
In an aging of receivables, the outstanding receivables that a company holds are broken
down and classified according to how long each receivable has been outstanding (30-
60 days, 60-90 days, 90-120 days, over 120 days are commonly-used classifications)
and the total balances outstanding in each category are calculated.
Explanation for Choice B:
In an aging of receivables, the specific accounts are identified by the time that they have
been outstanding. The average length of time that receivables have been outstanding is
not used.
Explanation for Choice C:
The aging of receivables deals with receivables, an asset, not the company's short-term
liabilities.
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Section B - Corporate Finance.
Answers
Explanation for Choice D:
The aging of receivables is a schedule of the receivables that have not been collected,
not a schedule of those that have been collected.
269. Question ID: CMA 1296 1.13 (Topic: Accounts Receivable Management)
Which one of the following statements is most correct if a seller extends credit to a
purchaser for a period of time longer than the purchaser's operating cycle? The seller

 A. will have a lower level of accounts receivable than those companies whose credit
period is shorter than the purchaser's operating cycle.
 B. can be certain that the purchaser will be able to convert the inventory into cash before
payment is due.
 C. is, in effect, financing more than just the purchaser's inventory needs.correct
 D. has no need for a stated cash discount rate or credit period.
Question was not answered
Correct Answer Explanation:
If the seller extends credit that is a longer period of time than the buyer's operating
cycle, the seller is providing longer financing than the buyer needs. Because the
operating cycle is shorter than the credit terms, the buyer will have sold the inventory
that they purchased on credit and collected the cash before the purchase needs to be
paid for. Therefore, the buyer will be able to use the money elsewhere for some period
of time before needing to repay the loan. This provides the buyer with financing for more
than the inventory itself.
Explanation for Choice A:
The operating cycle of the buyer does not impact the level of receivables that the seller
will hold.
Explanation for Choice B:
While it is likely that the inventory will be converted into cash before the payment is due,
it is not certain. The operating cycle is based on averages and for this specific inventory,
maybe the actual time for collection will be longer than the operating cycle.
Explanation for Choice D:
The operating cycle of the buyer does not impact whether or not there is a need for a
cash discount rate and a credit period.
270. Question ID: CMA 1296 1.18 (Topic: Accounts Receivable Management)
Which of the following represents a firm's average gross receivables balance?
I. Days' sales in receivables × accounts receivable turnover.
II. Average daily credit sales × average collection period.
 Hock P2 2020
Section B - Corporate Finance.
Answers
III. Net sales ÷ average gross receivables.

 A. II only.correct
 B. I and II only.
 C. I only.
 D. II and III only.
Question was not answered
Correct Answer Explanation:
This is one of the ways in which the average receivables balance may be calculated.
Multiplying the average credit sales each day by the average number of days
receivables are outstanding provides the average receivables balance.
Explanation for Choice B:
Neither of the items in item I are dollar amounts so they cannot together calculate the
average receivables balance.
Explanation for Choice C:
Neither of these items are dollar amounts so they cannot together calculate the average
receivables balance.
Explanation for Choice D:
This answer cannot be correct because item III includes the value that we are trying to
solve for.
271. Question ID: CMA 697 1.9 (Topic: Accounts Receivable Management)
Clauson Inc. grants credit terms of 1/15, net 30 and projects gross sales for next year of
$2,000,000. The credit manager estimates that 40% of their customers pay on the
discount date, 40% on the net due date, and 20% pay 15 days after the net due date.
Assuming uniform sales and a 360-day year, what is the projected days' sales
outstanding (rounded to the nearest whole day)?

 A. 30 days.
 B. 27 days.correct
 C. 24 days.
 D. 20 days.
Question was not answered
Correct Answer Explanation:
There are three days on which cash will be collected: at 15 days, 30 days and 45 days.
We can calculate the average days outstanding by taking a weighted average of these
 Hock P2 2020
Section B - Corporate Finance.
Answers
three days. The formula is [(15 × 0.40) + (30 × 0.4) + (45 × 0.2)]. Doing the math, we get
an average of 27 days of receivables outstanding.
Explanation for Choice A:
This is a simple average of the times to collection. The number of days' sales
outstanding is a weighted average of the times to collection.
Explanation for Choice C:
This answer is a weighted average of the times to collection, but it disregards the fact
that 20% of the receivables are paid 15 days past the net due date and instead includes
those past-due receivables with the receivables paid on day 30.
Explanation for Choice D:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
272. Question ID: ICMA 10.P2.170 (Topic: Inventory Management)
Moss Products uses the Economic Order Quantity (EOQ) model as part of its inventory
management process. A decrease in which one of the following variables would
increase the EOQ?

 A. Annual sales.
 B. Cost per order.
 C. Safety stock level.
 D. Carrying costs.correct
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
If the factors in the numerator (the cost of placing an order and the periodic demand)
increase, it will cause the EOQ to increase and vice versa. If the factor in the
denominator (the carrying cost per unit per period) increases, it will cause the EOQ to
decrease, and vice versa.
The carrying cost per unit is in the denominator and thus a decrease in the carrying cost
will result in an increase in the economic order quantity.
Explanation for Choice A:

If the factors in the numerator (the cost of placing an order and the periodic demand, or
annual sales) increase, it will cause the EOQ to increase and vice versa. If the factor in
the denominator (the carrying cost per unit per period) increases, it will cause the EOQ
to decrease, and vice versa.
The periodic demand, or annual sales, is in the numerator and thus an decrease in the
periodic demand will result in a decrease in the economic orderquantity, not an
increase.
Explanation for Choice B:

If the factors in the numerator (the cost of placing an order and the periodic demand)
increase, it will cause the EOQ to increase and vice versa. If the factor in the
denominator (the carrying cost per unit per period) increases, it will cause the EOQ to
decrease, and vice versa.
The cost per order is in the numerator and thus a decrease in the cost per order will
result in an decrease in the economic order quantity, not an increase.
 Hock P2 2020
Section B - Corporate Finance.
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Explanation for Choice C:
The safety stock level is not a part of the Economic Order Quantity model. Thus a
change in the safety stock level will have no effect on the economic order quantity.
273. Question ID: ICMA 19.P2.066 (Topic: Inventory Management)
During inflationary periods, last-in, first-out inventory accounting will generally have a

 A. lower cost of goods sold and lower inventory value.

 B. higher cost of goods sold and lower inventory value.correct
 C. higher cost of goods sold and higher inventory value.
 D. lower cost of goods sold and higher inventory value.
Question was not answered
Correct Answer Explanation:
The normal assumption for inventory calculations is that there is a period of inflation.
Inflation causes prices to rise and with LIFO, the most recent purchases (most
expensive) are considered to have been sold. This leads to a higher COGS. Under
LIFO the older (cheaper) units are considered to not have been sold and that leads to a
lower ending inventory value than under FIFO and other methods.
Explanation for Choice A:
In a period of inflation, LIFO leads to a higher cost of goods sold and a lower inventory
value.
Explanation for Choice C:
In a period of inflation, LIFO leads to a higher cost of goods sold and a lower inventory
value.
Explanation for Choice D:
In a period of inflation, LIFO leads to a higher cost of goods sold and a lower ending
inventory value.
274. Question ID: ICMA 10.P2.169 (Topic: Inventory Management)
Which one of the following statements concerning the economic order quantity (EOQ)
is correct?

 A. Increasing the EOQ is the best way to avoid stockouts.

 B. The EOQ results in the minimum ordering cost and minimum carrying cost.
 C. The EOQ model assumes constantly increasing usage over the year.
 D. The EOQ model assumes that order delivery times are consistent.correct
Question was not answered
 Hock P2 2020
Section B - Corporate Finance.
Answers
Correct Answer Explanation:
One of the assumptions of the EOQ model is that the required lead time to receive an
order is known and is consistent.
Explanation for Choice A:
The best way to avoid stockouts is to maintain an appropriate level of safety stock.
Explanation for Choice B:
The Economic Order Quantity model does not result in the minimum ordering
cost and the minimum carrying cost as separate items. However, it does minimize
the total cost of ordering and holding inventory.
Explanation for Choice C:
One of the assumptions of the EOQ model is that the demand for the inventory item is
known and is constant (not steadily increasing).
275. Question ID: CMA 1294 1.21 (Topic: Inventory Management)
An example of a carrying cost is

 A. Handling costs.
 B. Quantity discounts lost.
 C. Spoilage.correct
 D. Disruption of production schedules.
Question was not answered
Correct Answer Explanation:
Spoilage is an example of the costs incurred from carrying inventory. If the company
held no inventory, there would be no costs for spoilage.
Explanation for Choice A:
This is a cost of receiving inventory, and therefore is a cost of ordering inventory.
Explanation for Choice B:
Purchasing costs can be affected by discounts for size of purchases, and a quantity
discount lost can increase purchasing costs. It is not an inventory carrying cost.
Explanation for Choice D:
Disruptions in the production schedule is a cost of a stockout. This is in essence the
opposite of the cost of carrying inventory.
276. Question ID: CMA Sample Q1.8 (Topic: Inventory Management)
A major supplier has offered Alpha Corporation a year-end special purchase whereby
Alpha could purchase 180,000 cases of sport drink at $10 per case. Alpha normally
 Hock P2 2020
Section B - Corporate Finance.
Answers
orders 30,000 cases per month at $12 per case. Alpha's cost of capital is 9%. In
calculating the overall opportunity cost of this offer, the cost of carrying the increased
inventory would be

 A. $81,000
 B. $32,400correct
 C. $40,500
 D. $64,800
Question was not answered
Correct Answer Explanation:
Normally Alpha orders 30,000 cases per month for $12 a case, or a total of $360,000
per month. If they buy this at the beginning of the month and then use it down to zero by
month end, the average inventory level outstanding during the month is ($360,000 + $0)
÷ 2, which is $180,000 per month.
Since Alpha normally orders 30,000 cases per month, 180,000 cases would be a 6-
month supply (180,000 ÷ 30,000 = 6).
If they make this new purchase, they would spend a total of $1,800,000 for a 6-month
supply, and their average inventory during this six months would be $900,000:
($1,800,000 + $0) ÷ 2. Under this new plan, the average inventory will be $720,000
higher than under the old plan ($900,000 − $180,000). This is money that would not be
able to be used for other purposes. So, the cost of tying this money up in inventory for 6
months is ($720,000 × 9%) ÷ 2, or $32,400. (We divide by 2 since the 9% is an annual
rate, and we are looking at only a 6-month period.)
Explanation for Choice A:
This is $1,800,000, the total spent for a six-month supply, divided by 2 and the result
multiplied by 0.09. $1,800,000 divided by 2 is the average inventory level for the six
month period. However, what is important is the amount by which average inventory
would increase as a result of the 6-month purchase, i.e., the incremental increase in
inventory. Furthermore, multiplying by 0.09 results in the cost of capital for a full year,
whereas the time period for this purchase is only 6 months, or one-half of a year.
Explanation for Choice C:
This is the cost of capital to carry the inventory under the new plan, not the cost of
the incremental inventory that is held under the new plan compared to the old plan, i.e.,
the amount of increase in average inventory. See the correct answer for a complete
explanation.
Explanation for Choice D:
This is the interest cost for 12 months, not six months as this question requires. Since
Alpha normally orders 30,000 cases per month and the supplieer has offered the
 Hock P2 2020
Section B - Corporate Finance.
Answers
company the opportunity of purchasing 180,000 cases, the 180,000 cases is a 6-month
supply (180,000 ÷ 30,000).
277. Question ID: CMA 692 1.22 (Topic: Inventory Management)
The optimal level of inventory is affected by all of the following except the

 A. Cost per unit of inventory.

 B. Current level of inventory.correct
 C. Usage rate of inventory per time period.
 D. Cost of placing an order for merchandise.
Question was not answered
Correct Answer Explanation:
The current level of inventory held by the company does not influence what the optimal
level of inventory should be.
Explanation for Choice A:
The cost per unit of inventory will directly impact the level of inventory that should be
held. If the inventory is cheap, there is less opportunity cost from holding the inventory.
Explanation for Choice C:
The rate of usage of inventory will directly impact the level of inventory that should be
held.
Explanation for Choice D:
The cost of placing an order for inventory will impact the optimal level of inventory to
hold. If it is expensive to place an order, the company will make fewer orders, but for
more units each time. This will increase the level of inventory that they will hold in order
to minimize all costs associated with inventory.
278. Question ID: CMA 1294 4.7 (Topic: Inventory Management)
Which one of the following items is not directly reflected in the basic economic order
quantity (EOQ) model?

 A. Public warehouse rental charges.

 B. Interest on invested capital.
 C. Quantity discounts lost on inventory purchases.correct
 D. Inventory obsolescence.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
The EOQ model is the order quantity that balances ordering costs and carrying costs to
determine the optimal number of units that a company should order of a given product
each time it orders that item.
The EOQ formula includes annual demand, ordering costs and carrying costs. Carrying
costs include storing the inventory, insuring and securing the inventory, inventory taxes,
depreciation or rent of facilities, obsolescence and spoilage, and the opportunity cost of
the inventory investment. Ordering costs include the costs of placing an order (obtaining
purchase approvals, preparing and issuing purchase orders), the cost of receiving an
order, matching invoices received with purchase ordeers and receiving reports, and any
other special processing associated with ordering.
Quantity discounts lost on inventory purchases are part of purchasing costs. The
purchasing cost of inventory includes the cost of the inventory itself plus landing costs,
or incoming freight costs. Purchasing costs can be affected by discounts for size of
purchases, by missed discounts for not ordering enough to qualify for the discount, and
by suppliers’ credit terms, such as discounts for early payment. However, purchasing
costs are not included in the EOQ model.
Explanation for Choice A:
Public warehouse rental charges (for storing inventory) are reflected in the basic EOQ
model. They are a part of the carrying cost (part of k in the EOQ model).
Explanation for Choice B:
The opportunity cost of capital, which is interest lost on money invested in inventory
(that could be otherwise invested for a return), is reflected in the basic EOQ model. It is
a part of the carrying cost (part of k in the EOQ model).
Explanation for Choice D:
Inventory obsolescence is reflected in the basic EOQ model. It is a carrying cost (part of
k in the EOQ model).
279. Question ID: CMA 691 1.8 (Topic: Inventory Management)
The result of the economic order quantity formula indicates the

 A. Annual usage of materials during the year.

 B. Annual quantity of inventory to be carried.
 C. Safety stock plus estimated inventory for the year.
 D. Quantity of each individual order during the year.correct
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
By definition, the EOQ model calculates how many units of inventory should be ordered
each time an order is placed. The quantity is the quantity that will minimize the costs of
carrying inventory and the cost of a stockout.
Explanation for Choice A:
The annual usage of inventory during the period is used in the EOQ formula, but it is not
the result of the EOQ formula.
Explanation for Choice B:
The annual quantity of inventory to be carried during the period is used in the EOQ
formula, but it is not the result of the EOQ formula.
Explanation for Choice C:
The EOQ formula does not take into account the safety stock that is kept on hand.
280. Question ID: ICMA 10.P2.168 (Topic: Inventory Management)
Which one of the following is not explicitly considered in the standard calculation of
Economic Order Quantity (EOQ)?

 A. Quantity discounts.correct
 B. Level of sales.
 C. Carrying costs.
 D. Ordering costs.
Question was not answered
Correct Answer Explanation:

Quantity discounts are not included in the calculation of the Economic Order Quantity
(EOQ).
Explanation for Choice B:
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The demand for the inventory is explicitly incorporated into the EOQ model.
Explanation for Choice C:

Carrying costs are explicitly incorporated into the EOQ model.

Explanation for Choice D:

Ordering costs are explicitly incorporated into the EOQ model.

281. Question ID: CMA 692 1.24 (Topic: Inventory Management)
The level of safety stock in inventory management depends on all of the following
except the:

 A. Level of uncertainty of the sales forecast.

 B. Cost to reorder stock.correct
 C. Cost of running out of inventory.
 D. Level of customer dissatisfaction for back orders.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Question was not answered
Correct Answer Explanation:
The amount of safety stock that a company is required to hold will be affected by: 1) the
variability of the lead time, 2) the variability of the demand for the product, and 3) the
cost of stockout. The more variable either of the first two items are, the more safety
stock the company will need to carry to guard against stockouts in the case of an
unusually high demand or an unusually long lead time. If these items are more
consistent and predictable, the company can reduce the amount of its safety stock
because there is a smaller chance of needing so many items in stock. The greater the
cost of a stockout, the more safety stock the company will need to keep because the
potential loss from a stockout is higher.
Explanation for Choice A:
The more uncertain the sales forecast, the more safety stock the company will need to
keep. Therefore, the level of uncertainty of the future sales does impact the level of
safety stock. See the correct answer for a complete explanation.
Explanation for Choice C:
The greater the cost of running out of inventory, the more safety stock that the company
must hold. See the correct answer for a complete explanation.
Explanation for Choice D:
The greater the dissatisfaction that customers have in the case of a stockout, the more
safety stock that the company must hold. See the correct answer for a complete
explanation.
282. Question ID: ICMA 10.P2.167 (Topic: Inventory Management)
Carnes Industries uses the Economic Order Quantity (EOQ) model as part of its
inventory control program. An increase in which one of the following variables would
increase the EOQ?

 A. Ordering costs.correct
 B. Carrying cost rate.
 C. Purchase price per unit.
 D. Safety stock level.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
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If the factors in the numerator (the cost of placing an order and the periodic demand)
increase, it will cause the EOQ to increase and vice versa. If the factor in the
denominator (the carrying cost per unit per period) increases, it will cause the EOQ to
decrease, and vice versa.
Ordering costs is in the numerator and thus an increase in ordering costs will result in
an increase in the economic order quantity. That is because it will become more
economical to place fewer orders that are each larger in order to save on ordering
costs.
Explanation for Choice B:

If the factors in the numerator (the cost of placing an order and the periodic demand)
increase, it will cause the EOQ to increase and vice versa. If the factor in the
denominator (the carrying cost per unit per period) increases, it will cause the EOQ to
decrease, and vice versa.
The carrying cost rate is in the denominator and thus an increase in the carrying cost
rate will result in a decrease in the economic order quantity, not an increase.
Explanation for Choice C:
The purchase price per unit is not a factor in the Economic Order Quantity model. Thus,
a change in the purchase price per unit will not affect the economic order quantity.
Explanation for Choice D:
The safety stock level is not a factor in the Economic Order Quantity model. Thus, a
change in the safety stock level will not affect the economic order quantity.
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Section B - Corporate Finance.
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283. Question ID: ICMA 10.P2.164-ADAPTED (Topic: Inventory Management)
A review of the inventories of Cedar Grove Company shows the following cost data for
entertainment centers.

Invoice price $380.00 per unit

Freight and insurance on shipment 20.00 per unit
Insurance on inventory 15.00 per unit
Unloading 140.00 per order
Cost of placing orders 10.00 per order
Cost of capital 9% per annum
On average, an entertainment center remains in inventory for one month before it is
sold. What are the total carrying costs of inventory for an entertainment center?

 A. $18.00.correct
 B. $17.85.
 C. $49.20.
 D. $400.00.
Question was not answered
Correct Answer Explanation:
The freight and insurance on the shipment need to be included along with the invoice
price in calculating the cost of capital, because they are "landing costs" and are
inventoriable costs the same as the cost of the inventory is. So the cost of the inventory
is the $380 invoice price plus $20 for freight and insurance on the shipment, which
equals an inventory cost of $400 per unit.
The cost of capital is given as 9% per year. So if an entertainment center is held for one
month on average, the cost of capital to finance it is $400 × 0.09 ÷ 12, which equals
$3.00, and that is an inventory carrying cost. Insurance on the inventory while it is in
stock is $15, and that is another inventory carrying cost. The other costs are not
inventory carrying costs.
Therefore, the total carrying costs of inventory for one entertainment center are the
$3.00 cost of capital + $15.00 insurance on the unit while it is in inventory, or $18.00.
Explanation for Choice B:
This answer results from failing to include the freight and insurance on shipment as an
inventoriable cost in calculating the cost of capital to hold an entertainment center for
one month. The freight and insurance on the shipment need to be included along with
the invoice price in calculating the cost of capital, because they are "landing costs" and
 Hock P2 2020
Section B - Corporate Finance.
Answers
are inventoriable costs the same as the cost of the inventory is. So the cost of the
inventory is the $380 invoice price plus $20 for freight and insurance on the shipment,
which equals an inventory cost of $400 per unit. That is the amount that should be used
to calculate the cost of capital to carry the inventory.
Explanation for Choice C:
This answer results from two mistakes: (1) The cost of capital is calculated on the cost
of the entertainment center only. The freight and insurance on the shipment need to be
included along with the invoice price in calculating the cost of capital, because they are
"landing costs" and are inventoriable costs the same as the cost of the inventory is. So
the cost of the inventory is the $380 invoice price plus $20 for freight and insurance on
the shipment, which equals an inventory cost of $400 per unit. That is the amount that
should be used to calculate the cost of capital to carry the inventory. (2) The cost of
capital is calculated as if one entertainment center were held for one full year before
selling it. The problem says that on average, an entertainment center remains in
inventory for one month before it is sold. The cost of capital to hold it for one month is
only 1/12 the cost of capital to hold it for one year.
Explanation for Choice D:
This is the total of the invoice price and the freight and insurance on shipment for one
entertainment center. These are not inventory carrying costs. Please see the correct
answer for a complete explanation.
284. Question ID: CIA 593 IV.53 (Topic: Inventory Management)
A company serves as a distributor of products by ordering finished products once a
quarter and using that inventory to accommodate the demand over the quarter. If it
plans to ease its credit policy for customers, the amount of products ordered for its
inventory every quarter will be

 A. Increased to accommodate higher sales levels.correct

 B. Unaffected if the JIT inventory control system is used.
 C. Unaffected if safety stock is part of the current quarterly order.
 D. Reduced to offset the increased cost of carrying accounts receivable.
Question was not answered
Correct Answer Explanation:
If the company eases its credit policy, it will be giving credit to more customers and its
sales will increase. Therefore, the company will need to increase the level of inventory
on hand in order to meet the increased demand.
Explanation for Choice B:
Whether a JIT system is used or not, the company will need to carry more inventory to
meet the increased level of sales that will result from the change in the credit terms.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice C:
The change in the credit terms will lead to an increase in the level of sales of the
company. Therefore, they will need to carry more inventory.
Explanation for Choice D:
The change in the credit terms will lead to an increase in the level of sales of the
company. Therefore, they will need to carry more inventory, not less.
285. Question ID: CMA 697 1.12 (Topic: Inventory Management)
Which one of the following would not be considered a carrying cost associated with
inventory?

 A. Cost of capital invested in the inventory.

 B. Insurance costs.
 C. Shipping costs.correct
 D. Cost of obsolescence.
Question was not answered
Correct Answer Explanation:
Incoming shipping costs are part of "ordering costs" and are included in the
inventoriable cost of the inventory. Outgoing shipping costs are a selling cost. Neither
one is a carrying cost.
Explanation for Choice A:
This is a cost of carrying inventory.
Explanation for Choice B:
This is a cost of carrying inventory.
Explanation for Choice D:
This is a cost of carrying inventory.
286. Question ID: ICMA 10.P2.165 (Topic: Inventory Management)
Paint Corporation expects to use 48,000 gallons of paint per year costing $12 per
gallon. Inventory carrying cost is equal to 20% of the purchase price. The company
uses its inventory at a constant rate. The lead time for placing the order is 3 days, and
Paint Corporation holds 2,400 gallons of paint as safety stock. If the company orders
2,000 gallons of paint per order, what is the cost of carrying inventory?

 A. $5,280
 B. $5,760
 C. $2,400
 Hock P2 2020
Section B - Corporate Finance.
Answers
 D. $8,160correct
Question was not answered
Correct Answer Explanation:
The safety stock is 2,400 gallons, so that is the level below which inventory will never
fall. The company orders 2,000 gallons of paint at a time. Therefore, the average level
of inventory above the safety stock level is 1/2 of 2,000, or 1,000 gallons. Thus, the
average total amount of inventory on hand at any one time is 1,000 + 2,400, or 3,400
gallons. The inventory carrying charge is 20% of cost. The cost of the inventory on hand
is 3,400 × $12, or $40,800. 20% of $40,800 is $8,160.
Explanation for Choice A:
This answer results from adding the safety stock and the order quantity of 2,000 and
dividing the sum by 2 to average it. However, the amount of the safety stock is constant,
so that amount is already an average over time.
Explanation for Choice B:
This answer includes only the safety stock in the calculation of the inventory carrying
costs.
Explanation for Choice C:
This answer does not include the safety stock in the calculation of the inventory carrying
cost.
287. Question ID: CMA 1290 1.20 (Topic: Inventory Management)
The amount of inventory that a company would tend to hold in safety stock would
increase as the

 A. Sales level falls to a permanently lower level.

 B. Cost of running out of stock decreases.
 C. Cost of carrying inventory decreases.correct
 D. Variability of sales decreases.
Question was not answered
Correct Answer Explanation:
If the cost of holding decreases the company will probably increase their level of safety
stock. This is because the company needs to balance the cost of holding inventory with
the cost of a stockout in order to determine the level of safety stock. If the cost of
holding inventory decreases, they will be able to hold more inventory to avoid the cost of
a stockout.
Explanation for Choice A:
 Hock P2 2020
Section B - Corporate Finance.
Answers
If the level of sales falls permanently, the company will be able to reduce their level of
safety stock.
Explanation for Choice B:
If the cost of running out of stock (a stockout) decreases, the company will hold less
safety stock because the cost of running out is now lower. This is because the company
needs to balance the cost of holding inventory with the cost of a stockout in order to
determine the level of safety stock. If the cost of a stockout decreases, they will be able
to hold less inventory since the cost of s tockout is now smaller.
Explanation for Choice D:
If the variability of sales decreases, the company will be able to hold a lower level of
safety stock because they are better able to predict the inventory needs while they wait
for an order to be filled.
288. Question ID: CMA 1295 1.13 (Topic: Inventory Management)
Edwards Manufacturing Corporation uses the standard economic order quantity (EOQ)
model. If the EOQ for Product A is 200 units and Edwards maintains a 50 unit safety
stock for the item, what is the average inventory of Product A?

 A. 150 units.correct
 B. 125 units.
 C. 250 units.
 D. 100 units.
Question was not answered
Correct Answer Explanation:
Given that Edwards maintains a 50 unit safety stock, every time the next shipment of
inventory is received, there are 50 units in hand. This means that the lowest level of
inventory is 50 units. As soon as the order of inventory is received, the level of inventory
increases to 250 units, so this is the highest level of inventory. Adding these two
amounts together and dividing by 2 will give us the average inventory level: (50 + 250) ÷
2 = 150 units.
Explanation for Choice B:
This answer assumes that the EOQ is 250 units and that the company holds no safety
stock. See the correct answer for a complete explanation.
Explanation for Choice C:
This is the maximum level of inventory that will be held after a shipment is received. See
the correct answer for a complete explanation.
Explanation for Choice D:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This answer does not take into account the safety stock. See the correct answer for a
complete explanation.
289. Question ID: CMA 1295 1.5 (Topic: Inventory Management)
When the Economic Order Quantity (EOQ) model is used for a firm that manufactures
its inventory, ordering costs consist primarily of

 A. Obsolescence and deterioration.

 B. Insurance and taxes.
 C. Storage and handling.
 D. Production set-up.correct
Question was not answered
Correct Answer Explanation:
Production set-up is the equivalent of an ordering cost for a manufacturer. This question
is talking about Economic Lot Size, which is used by manufacturers to determine how
many units they should manufacture in each production run in order to balance their
setup costs with the cost of storing their completed inventory. The goal is to minimize
both the setup costs and the cost of storing completed inventory while still meeting
demand. The calculation of the Economic Lot Size is based on the same equation as is
used for Economic Order Quantity, except it uses the setup cost to manufacture a batch
of the product instead of the cost to place an order.
Explanation for Choice A:
Obsolescence and deterioration are classified as carrying costs.
Explanation for Choice B:
Insurance and taxes are classified as carrying costs.
Explanation for Choice C:
Handling—receiving orders and inspecting items received—is classified as an ordering
cost, but storage is classified as a carrying cost.
290. Question ID: CMA 1292 1.24 (Topic: Inventory Management)
Moore Company's budgeted sales and budgeted cost of sales for the coming year are
$54,000,000 and $36,000,000, respectively. Moore has made changes in its inventory
system that will increase turnover from its current level of nine times per year to 12
times per year. If short-term interest rates average 8%, Moore's cost savings in the
coming year will be

 A. $120,000.
 B. $40,000.
 C. $80,000.correct
 Hock P2 2020
Section B - Corporate Finance.
Answers
 D. $20,000.
Question was not answered
Correct Answer Explanation:
By increasing the number of times the inventory is turned over each year, Moore will
decrease the amount of inventory that is being held at any one point in time. Currently,
with inventory being turned over 9 times a year, the average inventory balance is
$4,000,000 ($36 million ÷ 9). If the inventory turnover is increased to 12 times, the
average inventory will be $3,000,000. The extra million dollars that would not be
invested in inventory would be available for other uses and with an 8% interest rate, will
provide Moore with a cost savings of $80,000 by not having $1 million tied up in
inventory.
Explanation for Choice A:
This answer is incorrect because it bases the calculation on the sales amount, not the
cost of goods sold figure. See the correct answer for a complete explanation.
Explanation for Choice B:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice D:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
291. Question ID: ICMA 10.P2.166 (Topic: Inventory Management)
James Smith is the new manager of inventory at American Electronics, a major
retailer. He is developing an inventory control system, and knows he should consider
 Hock P2 2020
Section B - Corporate Finance.
Answers
establishing a safety stock level. The safety stock can protect against all of the
following risks, except for the possibility that

 A. shipments of merchandise from the manufacturers is delayed by as much as one week.

 B. new competition may open in the company's market area.correct
 C. the distribution of daily sales will have a large variance, due to holidays, weather,
advertising, and weekly shopping habits.
 D. customers cannot find the merchandise they want, and they will go to the competition.
Question was not answered
Correct Answer Explanation:
Safety stock is a protection against stockouts which could cause lost sales. Having
safety stock cannot protect a company against the risk that new competition may open
in the company's market area.
Explanation for Choice A:
Safety stock is a protection against stockouts which could cause lost sales. A stockout
could be caused by shipments of merchandise from the manufacturer being delayed. So
having safety stock can protect a company against the risk of shipments of merchandise
from the manufacturer being delayed.
Explanation for Choice C:
Safety stock is a protection against stockouts which could cause lost sales. A stockout
could be caused by a large variance in the distribution of daily sales, i.e., heavy sales of
one product and virtually no sales of other products. So having safety stock can protect
a company against the distribution of daily sales will have a large variance, due to
holidays, weather, advertising, and weekly shopping habits.
Explanation for Choice D:
Safety stock is a protection against stockouts which could cause lost sales. If customers
cannot find the merchandise they want, they will go to the competition. Thus having
safety stock can protect a company against the risk of customers not being able to find
the merchandise they want and going to the competition.
292. Question ID: CMA 694 1.27 (Topic: Inventory Management)
All of the following are inventory carrying costs except

 A. Insurance.
 B. Opportunity cost of inventory investment.
 C. Inspections of received inventory.correct
 D. Storage.
Question was not answered
 Hock P2 2020
Section B - Corporate Finance.
Answers
Correct Answer Explanation:
The costs of inspecting inventory that is received is not a cost that increases as the time
that the inventory is held increases. Rather, it is the cost of receiving inventory and
therefore is better included as a cost of ordering inventory.
Explanation for Choice A:
Insurance is an example of the costs of carrying inventory.
Explanation for Choice B:
The opportunity cost of the investment in inventory is an example of the costs of
carrying inventory.
Explanation for Choice D:
Storage is an example of the costs of carrying inventory.
293. Question ID: CMA 696 1.17 (Topic: Inventory Management)
The amount of inventory that a company would tend to hold in stock would increase as
the

 A. Cost of carrying inventory decreases.correct

 B. Variability of sales decreases.
 C. Cost of running out of stock decreases.
 D. Sales level falls to a permanently lower level.
Question was not answered
Correct Answer Explanation:
If the cost of holding inventory decreases, the company will be more likely to hold larger
levels of inventory. This is because there is a lower cost to hold the inventory, and by
having more inventory there is less risk of a stockout.
Explanation for Choice B:
As the variability of sales decreases, the company will be able to hold lower levels of
inventory because there is less chance of a large demand that the company needs to
be prepared for.
Explanation for Choice C:
If the cost of running out of inventory decreases the company will hold less inventory
because of the lower cost of not having inventory.
Explanation for Choice D:
If sales fall permanently, the company should hold less inventory. See the correct
answer for a complete explanation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
294. Question ID: ICMA 1603.P2.011 (Topic: Inventory Management)
If a company implements a just-in-time inventory management program, it would expect
that its inventory turnover ratio will

 A. increase, and its days' sales in inventory will decrease.correct

 B. decrease, and its days' sales in inventory will increase.
 C. increase, and its days' sales in inventory will increase.
 D. decrease, and its days' sales in inventory will decrease.
Question was not answered
Correct Answer Explanation:
The inventory turnover ratio is the company's annualized cost of sales divided by its
average annual inventory. If the company implements a just-in-time inventory
management program, its average inventory levels should decline. A decrease in the
denominator of a ratio will cause an increase in the ratio, so the inventory turnover ratio
should be expected to increase as a result of implementing JIT inventory management.
The days' sales in inventory is 365 divided by the inventory turnover ratio. If the
inventory turnover ratio increases as a result of implementing JIT inventory
management, the denominator of the calculation will increase and the resulting days'
sales in inventory will decrease because 365 is being divided by a larger amount.
Explanation for Choice B:
The inventory turnover ratio is the company's annualized cost of sales divided by its
average annual inventory. If the company implements a just-in-time inventory
management program, its average inventory levels should decline. A decrease in the
denominator of a ratio will cause an increase in the ratio, not a decrease.
The days' sales in inventory is 365 divided by the inventory turnover ratio. If the
inventory turnover ratio increases as a result of implementing JIT inventory
management, the denominator of the calculation will increase and the resulting days'
sales in inventory will decrease, not increase, because 365 is being divided by a larger
amount.
Explanation for Choice C:
When the inventory turnover ratio increases, the days' sales in inventory must decrease,
and vice versa. Therefore, the inventory turnover ratio and the days' sales in inventory
cannot both increase.
Explanation for Choice D:
When the inventory turnover ratio decreases, the days' sales in inventory must increase,
and vice versa. Therefore, the inventory turnover ratio and the days' sales in inventory
cannot both decrease.
 Hock P2 2020
Section B - Corporate Finance.
Answers
295. Question ID: ICMA 10.P2.162 (Topic: Inventory Management)
All of the following are carrying costs of inventory except

 A. shipping costs.correct
 B. insurance.
 C. opportunity costs.
 D. storage costs.
Question was not answered
Correct Answer Explanation:
The carrying costs of inventory include storing the inventory, insuring and securing it,
paying inventory taxes on it, the depreciation or rent on inventory storage facilities,
obsolescence and spoilage of inventory, and the opportunity cost of the inventory
investment, or the lost interest for investing cash in inventory instead of in some other
longer-term investment that would return dividends or interest.
The way shipping costs are classified depends on whether they are incoming shipping
costs (shipping costs to receive the inventory from the supplier) or outgoing shipping
costs (shipping costs to send the product to the customers who have purchased it).
Incoming shipping costs are product costs and they are included in inventory along with
the cost of the items. Outgoing shipping costs are selling costs and are period costs.
But neither incoming nor outgoing shipping costs are classified as inventory carrying
costs.
Explanation for Choice B:
Insurance is a carrying cost of inventory.
Explanation for Choice C:
Opportunity costs are inventory carrying costs. The opportunity cost of inventory is the
cost of capital, or lost interest, for investing cash in inventory instead of in some other
longer-term investment that would return dividends or interest.
Explanation for Choice D:
Storage costs are carrying costs of inventory.
296. Question ID: CMA 1294 1.20 (Topic: Inventory Management)
Handy operates a chain of hardware stores across Ohio. The controller wants to
determine the optimum safety stock levels for an air purifier unit. The inventory manager
compiled the following data: The annual carrying cost of inventory approximates 20% of
the investment in inventory. The inventory investment per unit averages $50. The
stockout cost is estimated to be $5 per unit. The company orders inventory on the
average of 10 times per year. Total cost = carrying cost + expected stockout cost. The
probabilities of a stockout per order cycle with varying levels of safety stock are as
follows:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Safety stock Stockout Probability
200 0 0%
100 100 15%
0 100 15%
0 200 12%
The total cost of safety stock on an annual basis with a safety stock level of 100 units is:

 A. $1,950
 B. $1,750correct
 C. $2,000
 D. $550
Question was not answered
Correct Answer Explanation:
The total cost of the safety stock is the carrying cost plus the expected stockout cost.
If the company carries 100 units of safety stock, the cost of carrying the safety stock will
be $1,000 for the year. This is calculated as 20% of the value of the safety stock. The
average inventory investment per unit is $50. For 100 units, the carrying cost is $50 ×
100 × 0.20, or $1,000.
The stockout cost is $5 per unit. At a safety stock level of 100 units, if a stockout occurs,
the number of units the company would be short would be 100 units (from the
"Stockout" column). Therefore, the cost of one stockout would be 100 × $5, or $500.
The company orders inventory an average of 10 times per year. The probability of a
stockout occurring at a safety stock level of 100 units is 15%. Therefore, during a year's
time, the expected number of stockouts is 10 × 0.15, or 1.5 times. At a cost of $500 per
stockout, this is an expected annual cost of $750 ($500 × 1.5).
Since the total cost of the safety stock is the carrying cost plus the expected stockout
cost, the total cost of the safety stock on an annual basis with a safety stock level of 100
units is $1,000 carrying costs plus $750 stockout costs, or $1,750.
Explanation for Choice A:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
 Hock P2 2020
Section B - Corporate Finance.
Answers
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice C:
This answer can result from totaling the amounts in the "Stockout" column and
multiplying the total by the stockout cost of $5 per unit. The amount of the stockout to
use is only the amount at the level of the number of units of safety stock held.
Furthermore, this answer does not take into consideration the carrying cost of the safety
stock.
Explanation for Choice D:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
297. Question ID: ICMA 10.P2.163 (Topic: Inventory Management)
Valley Inc. uses 400 lbs. of a rare isotope per year. The isotope costs $500 per lb., but
the supplier is offering a quantity discount of 2% for order sizes between 30 and 79 lbs.,
and a 6% discount for order sizes of 80 lbs. or more. The ordering costs are $200.
Carrying costs are $100 per year per lb. of material and are not affected by the
discounts. If the purchasing manager places eight orders of 50 lbs. each, the total cost
of ordering and carrying inventory, including discounts lost, will be

 A. $12,100.correct
 B. $1,600.
 C. $6,600.
 D. $4,100.
Question was not answered
Correct Answer Explanation:
The total cost will include the lost discount (from ordering at the 2% discount level
instead of at the 6% discount level), ordering costs and carrying costs.
Lost discount cost: The company purchases 400 pounds at $500 per pound per year, at
a total cost of $200,000 (400 × $500). The cost of the lost discounts is the difference
 Hock P2 2020
Section B - Corporate Finance.
Answers
between 6% and 2% of $200,000, i.e., 4% multiplied by $200,000. $200,000 × 0.04 =
$8,000.
Ordering cost: $200 per order × 8 orders per year = $1,600.
Carrying cost: Each order consists of 50 pounds. It is assumed Valley Inc. will use those
50 pounds down to zero and then receive another order of 50. We must also assume
they will use the amount in each order at a steady rate. Therefore, the average number
of pounds in inventory throughout the year will be the average of 50 and 0, which is (50
+ 0) / 2, or 25 pounds. The carrying cost of $100 per pound is multiplied by these 25
pounds, and the cost is $2,500.
The total cost will be $8,000 + $1,600 + $2,500 = $12,100.
Explanation for Choice B:
This is the ordering cost only. The total cost of ordering and carrying the
inventory, including discounts lost, will include the lost discount (from ordering at the
2% discount level instead of at the 6% discount level), ordering costs and carrying
costs.
Explanation for Choice C:
This is the inventory ordering costs plus carrying costs, but the carrying costs are
calculated incorrectly. They are calculated using the number of units ordered each time
an order is placed. Furthermore, this answer does not include discounts lost.
The inventory carrying costs should be calculated using the average number of units in
inventory throughout the year, not the amount ordered each time an order is placed.
Explanation for Choice D:
This is the inventory ordering and carrying costs, but it does not include discounts lost.
The total cost of ordering and carrying the inventory, including discounts lost, will
include the lost discount (from ordering at the 2% discount level instead of at the 6%
discount level), ordering costs and carrying costs.
298. Question ID: CMA 1295 1.15 (Topic: Trade Credit)
Which one of the following provides a spontaneous source of financing for a firm?

 A. Debentures.
 B. Accounts payable.correct
 C. Accounts receivable.
 D. Mortgage bonds.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Accounts payable (or trade credit) is a spontaneous source of financing because it does
not need to be applied for before the transaction is entered into. It is created
automatically at the time of purchase.
Explanation for Choice A:
Debentures are not a source of spontaneous financing. Spontaneous financing occurs
without special effort on the part of the borrower. The borrower must issue debentures.
Explanation for Choice C:
Accounts receivable are not a source of spontaneous financing because in order to
finance through receivables, a factoring agreement must be entered into. Spontaneous
financing occurs without special effort on the part of the borrower.
Explanation for Choice D:
Mortgage bonds are not a source of spontaneous financing. Spontaneous financing
occurs without special effort on the part of the borrower. The borrower must issue
mortgage bonds.
299. Question ID: CMA 1294 1.18 (Topic: Trade Credit)
If a retailer's terms of trade are 3/10, net 45 with a particular supplier, what is the cost
on an annual basis of not taking the discount? Assume a 360-day year.

 A. 37.11%
 B. 36.00%
 C. 24.00%
 D. 31.81%correct
Question was not answered
Correct Answer Explanation:
This question is solved using the following formula:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Inputting the information from the question into the formula, we get 31.81%, as follows:
 Hock P2 2020
Section B - Corporate Finance.
Answers

360
0.03

× = 10.28571428 × 0.030927835 = 0.3181 or 31.81%.

45 − 10
1.00 − 0.03

This is the cost of not taking the discount.

Explanation for Choice A:
This question is solved using the following formula:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

This answer results from using 30 as the denominator in the first part of the formula.
However, the total period for payment is 45 days, and the period for the discount
payment is 10 days. 45 − 10 = 35, not 30.
Explanation for Choice B:
This question is solved using the following formula:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

This answer could result from two errors:

(1) Using 30 as the denominator in the first part of the formula. However, the total period
for payment is 45 days, and the period for the discount payment is 10 days. 45 − 10 =
35, not 30; and
(2) Using 0.03 as the second part of the formula. The second part of the formula should
be 0.03 ÷ (100% − Discount %).
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice C:
This answer results from two errors: (1) using the total period for payment in the
denominator of the first part of the formula for calculating the cost of not taking a cash
discount that is offered for early payment and (2) using 100% (or 1.00) in the
denominator of the second part of the formula. The denominator of the first part of the
formula should be Total Period for Payment − Period for Discount Payment. The
denominator of the second part of the formula should be 100% (or 1.00) minus the
discount % (or the discount % in decimal form). The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

300. Question ID: ICMA 10.P2.178 (Topic: Trade Credit)

A firm is given payment terms of 3/10, net 90 and forgoes the discount, paying on the
net due date. Using a 360-day year and ignoring the effects of compounding, what is
the effective annual interest rate cost?

 A. 13.9%.correct
 B. 12.4%.
 C. 13.5%.
 D. 12.0%.
Question was not answered
Correct Answer Explanation:
This is a straightforward question that is solved by using the formula for calculating the
cost of not taking a cash discount that is offered for early payment.
This formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment
 Hock P2 2020
Section B - Corporate Finance.
Answers
Inputting the information from the question into the formula, we get 13.9%, as follows:

360
0.03

× = 4.5 × 0.030927835 = 0.139 or 13.9%.

90 − 10
1.00 − 0.03

Explanation for Choice B:

This answer results from using the total period for payment in the denominator of the
first part of the formula for calculating the cost of not taking a cash discount that is
offered for early payment. The denominator should be Total Period for Payment −
Period for Discount Payment. The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Explanation for Choice C:

This answer results from using 100% (or 1.00) in the denominator of the second part of
the formula for calculating the cost of not taking a cash discount that is offered for early
payment. The denominator should be 100% (or 1.00) minus the discount % (or the
discount % in decimal form). The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Explanation for Choice D:

This answer results from two errors: (1) using the total period for payment in the
denominator of the first part of the formula for calculating the cost of not taking a cash
discount that is offered for early payment and (2) using 100% (or 1.00) in the
 Hock P2 2020
Section B - Corporate Finance.
Answers
denominator of the second part of the formula. The denominator of the first part of the
formula should be Total Period for Payment − Period for Discount Payment. The
denominator of the second part of the formula should be 100% (or 1.00) minus the
discount % (or the discount % in decimal form). The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

301. Question ID: CMA 1295 1.7 (Topic: Trade Credit)

Which one of the following statements concerning cash discounts is correct?

 A. The cost of not taking the discount is higher for terms of 2/10, net 60 than for 2/10, net
30.
 B. With trade terms of 2/15, net 60, if the discount is not taken, the buyer receives 45 days
of free credit.
 C. The cost of not taking a 2/10, net 30 cash discount is usually less than the prime rate.
 D. The cost of not taking a cash discount is generally higher than the cost of a bank
loan.correct
Question was not answered
Correct Answer Explanation:
Generally, the cost of not taking the discount is higher than the cost of a bank loan.
Therefore, in most cases the cash discount should be taken.
Explanation for Choice A:
The cost of not taking the discount is higher for credit terms of 2/10, net 30 than for
credit terms of 2/10, net 60 because the same discount is received for payment within
10 days, but the period for paying in full is shorter.
Explanation for Choice B:
The extra 45 days is not free credit because the customer loses the discount in order to
pay on day 60.
Explanation for Choice C:
A bank's prime rate is the rate it charges its most creditworthy borrowers. If we do the
math, we will determine that the cost of not taking this discount is 36%, which is higher
than the prime rate.
 Hock P2 2020
Section B - Corporate Finance.
Answers
302. Question ID: CMA 1296 1.12 (Topic: Trade Credit)
Which one of the following statements about trade credit is correct? Trade credit is

 A. not an important source of financing for small firms.

 B. usually an inexpensive source of external financing.
 C. subject to risk of buyer default.correct
 D. a source of long-term financing to the seller.
Question was not answered
Correct Answer Explanation:
Any type of credit is subject to the potential of default by the buyer (the borrower).
Explanation for Choice A:
Trade credit is a very important source of financing for small firms.
Explanation for Choice B:
When a discount is offered for payment within 10 days or so, trade credit is usually a
relatively expensive source of financing, as is demonstrated by the calculation of the
cost of not taking the discount.
Explanation for Choice D:
Trade credit is a source of short-term financing for the buyer.
303. Question ID: CMA 692 1.23 (Topic: Trade Credit)
If a firm's credit terms require payment within 45 days but allow a discount of 2% if paid
within 15 days (using a 360-day year), the approximate cost or benefit of the trade credit
terms is

 A. 24.49%.correct
 B. 48%.
 C. 2%.
 D. 16%.
Question was not answered
Correct Answer Explanation:
This question is solved using the following formula:

360
Discount %
×
 Hock P2 2020
Section B - Corporate Finance.
Answers
Total period for payment 100% − Discount %
− Period for discount payment

Inputting the information from the question into the formula, we get 24.49%, as follows:

360
0.02

× = 12 × 0.020408 = 0.2449 or 24.49%.

45 − 15
1.00 − 0.02

Explanation for Choice B:

This is (360 / 15) × (2 / 100) = 0.48 or 48%.
The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Explanation for Choice C:

This is the amount of the discount for paying within 15 days.
The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Explanation for Choice D:

This is (360 / 45) × (2 / 100) = 0.16 or 16%.
 Hock P2 2020
Section B - Corporate Finance.
Answers
The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

304. Question ID: CMA 691 1.6 (Topic: Trade Credit)

When a company offers credit terms of 2/10, net 30, the annual interest cost, based on
a 360-day year, is

 A. 35.3%.
 B. 24.0%.
 C. 36.0%.
 D. 36.7%.correct
Question was not answered
Correct Answer Explanation:
This question is solved using the following formula:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Inputting the information from the question into the formula, we get 36.7%, as follows:

360
0.02

× = 18 × 0.0204 = 0.367 or 36.7%.

30 − 10
1.00 − 0.02

Explanation for Choice A:

 Hock P2 2020
Section B - Corporate Finance.
Answers
This is (360 / 20) × (2 / 102) = 0.3529 or 35.3%.
The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Explanation for Choice B:

This is (360 / 30) × (2 / 100) = 0.24 or 24%.
The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Explanation for Choice C:

This is (360 / 20) × (2 / 100) = 0.36 or 36%.
The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

305. Question ID: CMA 687 1.28 (Topic: Trade Credit)

Richardson Supply has a $100 invoice payable with payment terms of 2/10, net 60.
Richardson can either take the discount or place the funds in a money market account
paying 6% interest. Using a 360-day year, Richardson's cost of not taking the cash
discount is
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. 6.2%.
 B. 6.4%.
 C. 8.7%.correct
 D. 12.2%.
Question was not answered
Correct Answer Explanation:
This question is a little bit more involved than the standard cash discount question
because we need to take into account the fact that Richardson can invest money at 6%
if they have it. If they pay within the discount period, they will save $2. However, if they
do not pay within the period, they will have an additional $98 available for 50 days that
they would not have had if they had paid early. That money will be able to earn 6%.
Over the 50 days, that $98 will earn $0.817 ($98 × 0.06 ÷ 360 × 50). This means that
they would have an incremental cost of $1.183 for the 50 days covered by this payable
($2 − $0.817). Dividing this by the $98 that they have available from not paying early,
we get a cost of 1.2%. However, this is rate for a period of only 50 days so it needs to
be multiplied by 7.2 (calculated as 360 ÷ 50) in order to calculate the annual rate. The
annual rate is 8.7%.
An alternative way of reaching the same answer is to calculate the cost of not taking the
discount and then subtract from that cost the annual rate that could be received by
investing the money in a money market account, as follows:
(360/[Total Period − Period for Discount]) × (Discount % / [100 − Discount %])
(360 / [60 − 10]) × (2 / [100 − 2]) = 7.2 × 0.0204 = 0.1469
0.1469 − 0.06 = 0.0869 or 8.7%
Explanation for Choice A:
This is {(360 / 60) × (2 / [100 − 2])} − 0.06. The first part of the formula is incorrect. It
should be (360 / [60 − 10]), the Total Period minus the Period for the Discount.
Explanation for Choice B:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice D:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This is (360 / 60) × (2 / [100 − 2]) = 6 × 0.0204 = 0.1224. This is incorrect for two
reasons. One, the first part of the formula is incorrect. It should be (360 / [60 − 10]), the
Total Period − Period for Discount. And two, it does not take into consideration the 6%
return available in a money market account.
306. Question ID: CMA 697 1.8-Adapted (Topic: Trade Credit)
Garo Company, a retail store, is considering foregoing cash discounts offered by its
suppliers for paying within the discount period in order to delay using its cash. Supplier
credit terms are 2/10, net 30. Assuming a 360-day year, what is the annual cost of credit
if the cash discount is not taken and Garo pays net 30?

 A. 36.0%
 B. 36.7%correct
 C. 24.0%
 D. 24.5%
Question was not answered
Correct Answer Explanation:
This question is solved using the following formula:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Inputting the information from the question into the formula, we get 36.7%, as follows:

360
0.02

× = 18 × 0.020408 = 0.367 or 36.7%.

30 − 10
1.00 − 0.02

Explanation for Choice A:

This answer results from using 100% (or 1.00) in the denominator of the second part of
the formula for calculating the cost of not taking a cash discount that is offered for early
 Hock P2 2020
Section B - Corporate Finance.
Answers
payment. The denominator should be 100% (or 1.00) minus the discount % (or the
discount % in decimal form).
This answer results from using the total period for payment in the denominator of the
first part of the formula for calculating the cost of not taking a cash discount that is
offered for early payment. The denominator of the first part of the formula should be
Total Period for Payment − Period for Discount Payment. The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Explanation for Choice C:

This answer results from two errors: (1) using the total period for payment in the
denominator of the first part of the formula for calculating the cost of not taking a cash
discount that is offered for early payment and (2) using 100% (or 1.00) in the
denominator of the second part of the formula. The denominator of the first part of the
formula should be Total Period for Payment − Period for Discount Payment. The
denominator of the second part of the formula should be 100% (or 1.00) minus the
discount % (or the discount % in decimal form). The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Explanation for Choice D:

This answer results from using the total period for payment in the denominator of the
first part of the formula for calculating the cost of not taking a cash discount that is
offered for early payment. The denominator of the first part of the formula should be
Total Period for Payment − Period for Discount Payment. The correct formula is:

360 × Discount %
 Hock P2 2020
Section B - Corporate Finance.
Answers

100% − Discount %
Total period for payment
− Period for discount payment

307. Question ID: ICMA 10.P2.159 (Topic: Trade Credit)

Global Manufacturing Company has a cost of borrowing of 12%. One of the firm's
suppliers has just offered new terms for purchases. The old terms were cash on delivery
and the new terms are 2/10, net 45. Should Global pay within the first ten days?

 A. No, the cost of not taking the discount exceeds the cost of borrowing.
 B. No, the use of debt should be avoided if possible.
 C. The answer depends on whether the firm borrows money.
 D. Yes, the cost of not taking the discount exceeds the cost of borrowing.correct
Question was not answered
Correct Answer Explanation:
The cost of not taking the discount is:
(360 / [45 – 10]) × 0.02 / 0.98
= 10.2857 × 0.020408
= 0.2099 or 20.99%
This is higher than the company’s borrowing cost of 12%. Therefore, Global should pay
within the first ten days because the cost of not taking the discount is greater than the
cost of borrowing.
Explanation for Choice A:
It is true that the cost of not taking the discount exceeds the company's cost of
borrowing. However, that does not mean that Global should not pay within the first ten
days to get the discount.
Explanation for Choice B:
Paying the supplier after the 10-day discount period is using debt. The debt is owed to
the supplier, and it has an interest cost. The interest cost is the difference between the
gross amount due the supplier if paid after the discount period and the net amount that
would be paid if the invoice is paid within the 10-day discount period.
The decision of whether or not to take the discount should be based on whether the
interest rate imputed in not taking the discount is greater than the interest cost to borrow
the funds to pay within the discount period.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Even if the company does not need to borrow to pay within the discount period, it will
have a cost for paying within the discount period. The cost will be an opportunity cost —
the interest the company could have earned had it invested the funds for 35 additional
days (45 days minus 10 days) before paying the invoice.
Explanation for Choice C:
Even if the company does not need to borrow to pay within the discount period, it will
have a cost for paying within the discount period. The cost will be an opportunity cost —
the interest the company could have earned had it invested the funds for 35 additional
days (45 days minus 10 days) before paying the invoice.
308. Question ID: ICMA 10.P2.177 (Topic: Trade Credit)
Dudley Products is given terms of 2/10, net 45 by its suppliers. If Dudley forgoes the
cash discount and instead pays the suppliers 5 days after the net due date, what is the
annual interest rate cost (using a 360-day year)?

 A. 18.4%.correct
 B. 24.5%.
 C. 21.0%.
 D. 18.0%.
Question was not answered
Correct Answer Explanation:
This is solved using the formula for the cost of not taking the discount, but it has a twist
to it.
The formula for the cost of not taking the discount is

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Instead of using the number of days Dudley is allowed to take to pay according to the
terms (45 days) as the total period for payment, we must use the number of days the
company would actually take to pay. The problem says Dudley would pay the suppliers
5 days after the net due date. Since the net due date is 45 days, we must use 50 days
in the formula as the total period for payment. Note that the question does not mention
anything about Dudley incurring any interest by paying 5 days late, so we assume
Dudley does not incur any interest by paying 5 days late.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Inputting the information from the question into the formula, we get 18.4%, as follows:

360
0.02

× = 9 × 0.020408 = 0.184 or 18.4%.

50 − 10
1.00 − 0.02

Explanation for Choice B:

This answer results from using 30 days as the denominator of the first part of the
formula for calculating the cost of not taking a cash discount that is offered for early
payment. The denominator of the first part of the formula should be Total Period for
Payment − Period for Discount Payment.
The formula for the cost of not taking the discount is

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

However, instead of using the number of days Dudley is allowed to take to pay
according to the terms (45 days) as the total period for payment, we must use the
number of days the company would actually take to pay. The problem says Dudley
would pay the suppliers 5 days after the net due date. Since the net due date is 45
days, we must use 50 days in the formula as the total period for payment. So the
denominator needs to be 50 − 10, or 40.
Explanation for Choice C:
The formula for the cost of not taking the discount is

360
Discount %
×
 Hock P2 2020
Section B - Corporate Finance.
Answers
Total period for payment 100% − Discount %
− Period for discount payment

This answer results from using the number of days Dudley is allowed to take to pay (45
days) as the total period for payment in the formula. However, the problem says Dudley
would pay the suppliers 5 days after the net due date. Since the net due date is 45
days, 5 days after the due date would be 50 days; so we must use 50 days in the
formula as the total period for payment.
Explanation for Choice D:
This answer results from using 100% (or 1.00) in the denominator of the second part of
the formula for calculating the cost of not taking a cash discount that is offered for early
payment. The denominator should be 100% (or 1.00) minus the discount % (or the
discount % in decimal form). The correct formula is:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

309. Question ID: CMA 1295 1.9 (Topic: Trade Credit)

Which one of the following financial instruments generally provides the largest source of
short-term credit for small firms?

 A. Bankers' acceptances.
 B. Installment loans.
 C. Commercial paper.
 D. Trade credit.correct
Question was not answered
Correct Answer Explanation:
Trade credit is the largest source of short-term credit for small firms.
Explanation for Choice A:
Bankers' acceptances are not a large source of short-term credit since they are a
guarantee of payment, not the credit itself.
Explanation for Choice B:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Installment loans are not usually short-term credit.
Explanation for Choice C:
Commercial paper is issued only by very large companies and is therefore not a large
source of credit for small firms.
310. Question ID: CMA 694 1.20 (Topic: Trade Credit)
Using a 360-day year, what is the opportunity cost to a buyer of not accepting terms of
3/10, net 45?

 A. 55.67%
 B. 31.81%correct
 C. 22.27%
 D. 101.73%
Question was not answered
Correct Answer Explanation:
This question is solved using the following formula:

360
Discount %

×
Total period for payment
100% − Discount %
− Period for discount payment

Inputting the information from the question into the formula, we get 31.81%, as follows:

360
0.03

× = 10.2857 × 0.030928 = 0.3181, or 31.81%.

45 − 10
1.00 − 0.03

Explanation for Choice A:

This answer results from using 30 days as the total period for payment instead of 45
days.
Explanation for Choice C:
This is not the correct answer. Please see the correct answer for an explanation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice D:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
311. Question ID: ICMA 10.P2.182 (Topic: Short-term Bank Loans and Other S-T
Financing)
Approximately what amount of compensating balance would be required for a stated
interest rate of 10% to equal an effective interest rate of 10.31% on a $100,000,000
one-year loan?

 A. Not enough information is given.

 B. $3,000,000.correct
 C. $310,000.
 D. $3,100,000.
Question was not answered
Correct Answer Explanation:
Annual Interest divided by Average Outstanding Principal = Effective Annual Interest
Rate. Therefore, Average Outstanding Principal × Effective Annual Interest Rate =
Annual Interest. And also, Annual Interest ÷ Effective Annual Interest Rate = Average
Outstanding Principal.
Interest on a $100,000,000 loan at 10% for one year would be $10,000,000
($100,000,000 × 0.10). We need to find what the net proceeds of a $100,000,000 loan
would be (after deducting the compensating balance) that will result in an effective
interest rate of 10.31%.
Since we know the interest amount ($10,000,000) and the rate (0.1031), we know
everything for that formula except the net principal amount. So let X represent the net
principal.
 Hock P2 2020
Section B - Corporate Finance.
Answers
10,000,000 / X = 0.1031.
Solving for X, we get X = $96,993,210. That is the net principal, after the compensating
balance is subtracted, because the amount of the compensating balance is not
available to the borrower.
To find the amount of the compensating balance, we subtract the net principal from the
gross loan amount of $100,000,000. $100,000,000 − $96,993,210 = $3,006,790. The
difference between that figure and this answer is simply rounding. If you subtract
$3,000,000 from $100,000,000, you get $97,000,000. $10,000,000 interest (interest at
10% on $100,000,000) divided by a net principal amount of $97,000,000 is 10.309%, or
rounded, 10.31%.
Explanation for Choice A:
Enough information is given to answer the question.
Explanation for Choice C:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice D:
This answer results from dividing 10.31% of $100,000,000 by 10%. 10.31% of
$100,000,000 is not the cash amount of interest being charged on the loan. The cash
amount of interest being charged on the loan is 10% of $100,000,000. The correct
answer to this question is the difference between the gross amount of the loan
($100,000,000) and the net amount of the loan (the amount available after subtracting
the compensating balance from the gross amount). The net amount of the loan is the
cash amount of interest being charged on the loan divided by 10.31%.
312. Question ID: CIA 594 IV.51 (Topic: Short-term Bank Loans and Other S-T
Financing)
A manufacturing firm wants to obtain a short term loan and has approached several
lending institutions. All of the potential lenders are offering the same nominal interest
rate but the terms of the loans vary. Which of the following combinations of loan terms
will be most attractive for the borrowing firm?

 A. Discount interest, no compensating balance.

 Hock P2 2020
Section B - Corporate Finance.
Answers
 B. Simple interest, 20% compensating balance required.
 C. Simple interest, no compensating balance.correct
 D. Discount interest, 20% compensating balance required.
Question was not answered
Correct Answer Explanation:
Discounted interest and compensating balances both cause the effective interest rate to
be higher than the stated rate for the loan. Therefore, the loan that offers simple interest
and no compensating balance will have a lower effective rate than a loan with
discounted interest and/or a compensating balance requirement.
Explanation for Choice A:
Discounted interest causes the effective interest rate to be higher than the stated rate
for the loan. Therefore, a discounted interest loan will not be more attractive for the
borrowing firm.
Explanation for Choice B:
A compensating balance causes the effective interest rate to be higher than the stated
rate for the loan. Therefore, a loan with a compensating balance requirement will not be
more attractive for the borrowing firm.
Explanation for Choice D:
Discounted interest and compensating balances both cause the effective interest rate to
be higher than the stated rate for the loan. Therefore, a loan with discounted interest
and a compensating balance requirement will not be more attractive for the borrowing
firm.
313. Question ID: CMA 1294 1.23 (Topic: Short-term Bank Loans and Other S-T
Financing)
If a firm borrows $500,000 at 10% and is required to maintain $50,000 as a minimum
compensating balance at the bank, what is the effective interest rate on the loan?

 A. 11.1%correct
 B. 9.1%
 C. 12.2%
 D. 10.0%
Question was not answered
Correct Answer Explanation:
A compensating balance increases the effective interest rate of a loan because not all of
the borrowed money is actually available to the borrower. In a compensating balance
agreement, the amount of the compensating balance is withheld from the monies given
 Hock P2 2020
Section B - Corporate Finance.
Answers
to the borrower. However, the borrower must pay interest on the full amount of the loan,
including the compensating balance. So in this case, the borrower will pay $50,000 in
interest per year ($500,000 × 10%). However, because of the $50,000 compensating
balance, they will receive only $450,000. This makes the effective interest rate 11.1%
($50,000 ÷ $450,000).
Explanation for Choice B:
A compensating balance increases the effective interest rate of a loan because not all of
the borrowed money is actually available to the borrower. This rate is lower than the
stated rate of 10%. It results from adding the amount of the compensating balance to
the loan proceeds instead of subtracting it.
Explanation for Choice C:
This answer results from multiplying the stated interest rate of 10% by the loan balance
plus the compensating balance and dividing the result by the amount of funds available
to the borrower. The amount of interest due is based on the full amount of the loan but
not on the full amount of the loan plus the compensating balance.
Explanation for Choice D:
This is the nominal rate of interest on the loan, not the effective interest rate. See the
correct answer for a complete explanation.
314. Question ID: CMA 1296 1.16 (Topic: Short-term Bank Loans and Other S-T
Financing)
The Frame Supply Company has just acquired a large account and needs to increase
its working capital by $100,000. The controller of the company has identified a number
of sources. One of them is:
Issue $110,000 of 6-month commercial paper to net $100,000. (New paper would be
issued every 6 months.)
Assume a 360-day year in all of your calculations.
The cost of this alternative is

 A. 18.2%
 B. 20.0%correct
 C. 9.1%
 D. 10.0%
Question was not answered
Correct Answer Explanation:
When the company issues the commercial paper they will receive $100,000.
Commercial paper is issued at a discount. The face amount and the amount the
 Hock P2 2020
Section B - Corporate Finance.
Answers
company needs to repay is $110,000 so the difference between that and the amount the
receive is interest. However, the term of the commercial paper is only 6 months, so this
needs to be done twice a year. Therefore, the annual cost of borrowing $100,000 will be
$20,000, so the effective annual interest rate is 20% ($20,000 divided by the $100,000
net proceeds available to the company all year).
Explanation for Choice A:
This is $10,000 × 2 / $110,000. The cost in terms of an annual rate is the amount of
interest paid during the course of a year ($10,000 × 2) divided by the amount of cash
the company receives from the issuance of the commercial paper, assumed to be
outstanding for a year. The amount of cash the company will receive from issuing the
commercial paper is only $100,000, not $110,000. (It will receive $100,000 and in 6
months it will have to repay $110,000, representing the principal received of $100,000
plus interest for 6 months of $10,000; and then it will have to issue the commercial
paper again for another 6 months.) So to calculate the cost as an annual percentage,
we need to divide the interest paid for one full year by the amount of funds available for
one full year from the two issuances.
Explanation for Choice C:
This is $10,000 (interest for 6 months) divided by $110,000. This is incorrect for two
reasons. One, interest rates are always annual interest rates, and this interest is for only
6 months. The interest for 6 months needs to be annualized by multiplying it by 2. The
interest for one full year will be 2 × $10,000. And two, the funds available will be only
$100,000, not $110,000. Commercial paper is sold at a discount. For each commercial
paper issue, the company will receive $100,000 and in 6 months it will have to repay
$110,000, representing the principal received of $100,000 plus interest for 6 months of
$10,000. The annual interest rate is the total interest for one full year divided by the
usable funds received, assumed to be outstanding for one full year.
Explanation for Choice D:
This is the effective rate for one of the issuances of commercial paper, but since it is
only for 6 months, this needs to be doubled.
315. Question ID: ICMA 10.P2.174 (Topic: Short-term Bank Loans and Other S-T
Financing)
A manufacturer with seasonal sales would be most likely to obtain which one of the
following types of loans from a commercial bank to finance the need for a fixed amount
of additional working capital during the busy season?

 A. Installment loan.
 B. Unsecured short-term term loan.correct
 C. Insurance company term loan.
 D. Transaction loan.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Question was not answered
Correct Answer Explanation:
A short-term loan is a loan with a maturity date of less than one year in the future. A
short-term loan, either secured or unsecured, would be an appropriate type of loan to be
used to finance the need for a fixed amount of additional working capital during the busy
season.
The collection of receivables from the selling season is the source of the repayment of
the loan, so the loan should be paid off about a month following the end of the
company’s busy season. Therefore, the loan should have a maturity date of about one
month beyond the end of the company’s busy season, so the company will have a
chance to collect the receivables from the selling season to use to pay off the loan.
If the loan cannot be paid off on its maturity date, then something is wrong, because it
means the company has used the collection of the receivables for something other than
to pay off the seasonal loan.
Explanation for Choice A:
An installment loan is a type of long-term financing, and it would have a maturity date of
at least one year in the future. Installment loans are generally used for the purchase of
vehicles and other smaller fixed assets.
Financing that provides additional working capital to support the busy season is short-
term financing, because it can be repaid when the busy season is over and the
receivables from the sales are collected. So an installment loan would not be
appropriate for this purpose.
Explanation for Choice C:
An insurance company term loan, or any term loan no matter who the lender is, would
be used for long-term financing. A term loan is a loan made to a business for long-term
needs, such as purchase of fixed assets, that has a maturity date of one year or more in
the future.
Financing that provides additional working capital to support the busy season is short-
term financing, because it can be repaid when the busy season is over and the
receivables from the sales are collected. So a term loan would not be appropriate for
this purpose.
Explanation for Choice D:
A transaction loan is a loan made for a specific purchase, such as a mortgage loan
made for the purchase of real estate or a term loan made for the purchase of
equipment. Usually, the disbursement check is made out to the seller of the item, so the
lender can be certain that the loan is being used for its designated purpose.
 Hock P2 2020
Section B - Corporate Finance.
Answers
A working capital loan such as the one mentioned in this problem would not be called a
transaction loan, because it would not be used to make just a single purchase from a
single supplier. It would probably be used for multiple inventory purchases from multiple
suppliers, possibly over a period of several months. So it would not be practical for the
loan to be disbursed by means of checks made payable to each of the suppliers.
316. Question ID: ICMA 10.P2.184 (Topic: Short-term Bank Loans and Other S-T
Financing)
Todd Manufacturing Company needs a $100 million loan for one year. Todd’s banker
has presented two alternatives as follows:
Option #1 - $100 million loan with a stated interest rate of 10.25%. No compensating
balance required.
Option #2 - $100 million loan with a stated interest rate of 10.00%. Non-interest bearing
compensating balance required.
Which of the following compensating balances, withheld from the loan proceeds, would
result in Option #2 having an effective interest rate equal to the 10.25% rate of Option
#1?

 A. $10,250,000.
 B. $2,440,000.correct
 C. $250,000.
 D. $2,500,000.
Question was not answered
Correct Answer Explanation:
The effective annual interest rate on a loan with a compensating balance when no
interest is received on the compensating balance is the annual interest due divided by
the net funds the borrower will have available to use.
Option #2 is a $100,000,000 loan with a stated interest rate of 10%. On a $100,000,000
loan at 10%, the interest due for one year would be $10,000,000.
We next need to find the net funds available to the borrower that would cause the
effective annual interest rate to be 10.25% when the interest due for one year is
$10,000,000. Once we have that, we can calculate what the compensating balance
requirement is.
Let X = the net funds available to the borrower.
$10,000,000 ÷ X = 0.1025
X = $97,560,976
 Hock P2 2020
Section B - Corporate Finance.
Answers
Therefore, the compensating balance required is $100,000,000 − $97,560,976, which
equals $2,439,024.
$2,439,024.39 is not one of the answer choices given. The closest answer choice
among those given is $2,440,000, and the difference is simply a rounding difference.
We can confirm that and that this is the correct answer, as follows:
$100,000,000 − $2,440,000 = $97,560,000. Net available principal of $97,560,000
results in an effective annual interest rate of 10.25% when rounded, as follows:
$10,000,000 ÷ $97,560,000 = 0.102501025 or 10.25%, rounded.
Explanation for Choice A:
The effective annual interest rate on a loan with a compensating balance when no
interest is received on the compensating balance is the annual interest due divided by
the net funds the borrower will have available to use.
If the compensating balance on a $100,000,000 loan were $10,250,000, the net funds
available to the borrower would be $100,000,000 − $10,250,000, which is $89,750,000.
At a stated interest rate of 10%, as in Option #2, the annual interest due on the loan
would be $10,000,000.
The effective annual interest rate would be $10,000,000 ÷ $89,750,000, which is
11.142% or rounded, 11.14%. The requirement is that the effective annual interest rate
be 10.25%. This answer choice does not fulfill the requirement.
Explanation for Choice C:
The effective annual interest rate on a loan with a compensating balance when no
interest is received on the compensating balance is the annual interest due divided by
the net funds the borrower will have available to use.
If the compensating balance on a $100,000,000 loan were $250,000, the net funds
available to the borrower would be $100,000,000 − $250,000, which is $99,750,000.
At a stated interest rate of 10%, as in Option #2, the annual interest due on the loan
would be $10,000,000.
The effective annual interest rate would be $10,000,000 ÷ $99,750,000, which is
10.025% or rounded, 10.03%. The requirement is that the effective annual interest rate
be 10.25%. This answer choice does not fulfill the requirement.
Explanation for Choice D:
The effective annual interest rate on a loan with a compensating balance when no
interest is received on the compensating balance is the annual interest due divided by
the net funds the borrower will have available to use.
 Hock P2 2020
Section B - Corporate Finance.
Answers
If the compensating balance on a $100,000,000 loan were $2,500,000, the net funds
available to the borrower would be $100,000,000& − $2,500,000, which is $97,500,000.
At a stated interest rate of 10%, as in Option #2, the annual interest due on the loan
would be $10,000,000.
The effective annual interest rate would be $10,000,000 ÷ $97,500,000, which is
10.256% or rounded, 10.26%. The requirement is that the effective annual interest rate
be 10.25%. Although it is close, this answer choice does not fulfill the requirement.
317. Question ID: ICMA 10.P2.144 (Topic: Short-term Bank Loans and Other S-T
Financing)
Dexter Products receives $25,000 worth of merchandise from its major supplier on the
15th and 30th of each month. The goods are sold on terms of 1/15, net 45, and Dexter
has been paying on the net due date and foregoing the discount. A local bank offered
Dexter a loan at an interest rate of 10%. What will be the net annual savings to Dexter if
it borrows from the bank and utilizes the funds to take advantage of the trade discount?

 A. $1,575.
 B. $2,250.
 C. $525.
 D. $1,050.correct
Question was not answered
Correct Answer Explanation:
The company can save 1% on each order by taking the discount. That is $25,000 × 0.01
= $250. If the company borrows from a bank in order to make the payment on each
order by the discount date (15 days after receipt and 30 days before they usually pay),
they will have to borrow $24,750 for each order ($25,000 − $250). To be equivalent to
the additional time they are now taking to pay for each order, each borrowing from the
bank will have to be for 30 days (45 days – 15 days).
Interest paid to the bank for each 30-day borrowing at the rate of 10% per year will be:
$24,750 × 0.10 ÷ 360 days in a year × 30 days = $206.25.
The amount of savings for paying by day 15 is $250.
So the amount the company can save on each order by borrowing from the bank and
paying by the discount date (15 days) is the difference between the $250 discount and
the bank’s interest charge for using $24,750 for 30 days, which is $206.25. The
difference between $250 and $206.25 is $43.75 savings per order.
The company places 24 orders per year (2 per month). Therefore, the total savings per
year is $43.75 × 24, or $1,050 per year.
Explanation for Choice A:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice B:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice C:
This is the cost of not taking the discount minus the interest rate on the loan multiplied
by $24,750, the amount the company will pay for each order if it takes the discount. This
is not the way to calculate the annual savings to Dexter if it borrows from the bank and
utilizes the funds to take advantage of the trade discount.
The difference between the amount saved on each order by taking the discount and the
amount paid in interest for the amount borrowed for each order multiplied by the number
of orders per year is the total savings per year.
318. Question ID: ICMA 10.P2.143 (Topic: Short-term Bank Loans and Other S-T
Financing)
Mandel Inc. has a zero-balance account with a commercial bank. The bank sweeps any
excess cash into a commercial investment account earning interest at the rate of 4%
per year, payable monthly. When Mandel has a cash deficit, a line of credit is used
which has an interest rate of 8% per year, payable monthly based on the amount used.
Mandel expects to have a $2 million cash balance on January 1 of next year. Net cash
flows for the first half of next year, excluding the effects of interest received or paid, are
forecasted (in millions of dollars) as follows.

Jan Feb Mar Apr May Jun

Net cash inflows (millions of dollars) +2 +1 −5 −3 −2 +6
Assuming all cash flows occur at the end of each month, approximately how much
interest will Mandel incur for the first half of next year?
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. $195,000 net interest paid.
 B. $76,000 net interest paid.
 C. $53,000 net interest paid.
 D. $16,000 net interest paid.correct
Question was not answered
Correct Answer Explanation:
All cash flows are assumed to occur at the end of each month. Therefore, when money
is borrowed on the line of credit at month end or is outstanding on the line at the end of
a month, the interest on it is not due until the end of the following month, because then
the loan will have been outstanding for one month’s time and will have accrued one
month’s interest. And when interest is earned, it is earned on invested funds that have
been invested for one month. Calculation of the ending investment or loan balance must
include the amount of interest the company will either be receiving or paying at the end
of the month.
Here are the forecasted cash flows and the relevant interest earned on invested funds
and paid on borrowings each month during the first half of next year.

Ending
Net Oper. Interest Earned Interest Incurred Investment
Date Cash Flow on Investment on Loan (Loan) Balance
Jan. 1 $2,000,000
(2,000,000 × 0.04/12)
Jan. 31 +2,000,000 =6,667 -0- 4,006,667
(4,006,667 × 0.04/12)
Feb. 28 +1,000,000 =13,356 -0- 5,020,023
(5,020,023 × 0.04/12)
Mar. 31 −5,000,000 =16,733 -0- 36,756
(36,756 × 0.04/12)
Apr. 30 −3,000,000 =123 -0- (2,963,121)
(2,963,121× 0.08/12)
May 31 −2,000,000 -0- =(19,754) (4,982,875)
(4,982,875 × 0.08/12)
June 30 +6,000,000 -0- =(33,219) 983,906
Totals 36,879 (52,973)
The amount of interest incurred/paid means the net amount of interest incurred, which is
interest earned on invested funds minus interest incurred/paid on borrowings. That is
 Hock P2 2020
Section B - Corporate Finance.
Answers
$36,879 interest earned minus $52,973 interest incurred/paid, which equals net interest
incurred/paid of $(16,094). That is approximately $16,000.
Explanation for Choice A:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice B:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice C:
This is approximately the amount of gross interest paid. However, it is not
the net interest paid. The amount of interest incurred/paid means the net amount of
interest incurred, which is interest earned on invested funds minus interest paid on
borrowings.
319. Question ID: CMA 696 1.11 (Topic: Short-term Bank Loans and Other S-T
Financing)
A company obtained a short-term bank loan of $250,000 at an annual interest rate of
6%. As a condition of the loan, the company is required to maintain a compensating
balance of $50,000 in its checking account. The company's checking account earns
interest at an annual rate of 2%. Ordinarily, the company maintains a balance of
$25,000 in its checking account for transaction purposes. What is the effective interest
rate of the loan?

 A. 5.80%
 B. 7.00%
 C. 6.66%
 D. 6.44%correct
 Hock P2 2020
Section B - Corporate Finance.
Answers
Question was not answered
Correct Answer Explanation:
In a loan with a compensating balance, the borrower pays interest on the full amount of
the loan but does not receive the use of the full amount of the loan in cash, since they
are required to leave some of it on deposit as a compensating balance.
In this case, since they already maintain a $25,000 balance at the bank, they will need
to add only $25,000 from the loan proceeds to meet the compensating balance
requirement. Therefore, the company will have the use of $225,000 of the loan but they
will pay interest of 6% on the full $250,000 loan amount. $250,000 × 0.06 equals
$15,000 of annual interest expense. However, this interest expense is reduced by the
interest that will be earned on the money that was deposited to meet the compensating
balance requirement.
The incremental amount of the deposit increase is not the full $50,000 of the required
compensating balance, but only the $25,000 that the company needed to add to what
was already in the bank. Interest earned on additional $25,000 at 2% per annum equals
$500 interest received. This interest received offsets the larger interest cost, making a
net interest expense of $14,500.
The effective interest rate on the loan is thus $14,500 ÷ the $225,000 received, or
6.44%.
Explanation for Choice A:
This answer is incorrect because in a loan with a compensating balance the effective
interest rate is higher than the nominal interest rate. See the correct answer for a
complete explanation.
Explanation for Choice B:
This answer fails to take into consideration the fact that the company ordinarily
maintains a balance of $25,000 in its checking account for transaction purposes. Thus,
the amount of the loan proceeds that will be added to the checking account needs to be
only $25,000, not the full $50,000 required.
Explanation for Choice C:
This is $15,000 interest per year on the loan divided by the net usable loan proceeds of
$225,000. This answer fails to take into account the interest that will be earned on the
money deposited to meet the compensating balance requirement. See the correct
answer for a complete explanation.
320. Question ID: ICMA 10.P2.186 (Topic: Short-term Bank Loans and Other S-T
Financing)
 Hock P2 2020
Section B - Corporate Finance.
Answers
What is the effective annual interest rate for a one-year $100 million loan with a stated
interest rate of 8.00%, if the lending bank requires a non-interest bearing compensating
balance in the amount of $5 million?

 A. 8.00%.
 B. 7.62%.
 C. 8.42%.correct
 D. 13.00%.
Question was not answered
Correct Answer Explanation:
The effective annual interest rate on a loan with a compensating balance when no
interest is received on the compensating balance is the annual interest due divided by
the net funds the borrower will have available to use.
The annual interest due on a $100,000,000 loan with a stated interest rate of 8.00% is
$8,000,000. If the compensating balance requirement is $5,000,000, the net funds
available to the borrower to use will be $95,000,000. Thus, the effective annual interest
rate will be $8,000,000 ÷ $95,000,000, which is 0.0842 or 8.42%.
Explanation for Choice A:
8% is the stated rate of interest. The effective annual interest rate on a loan with a
compensating balance when no interest is received on the compensating balance is the
annual interest due divided by the net funds the borrower will have available to use.
That will be a different rate from the stated interest rate.
Explanation for Choice B:
This is $8,000,000 divided by $105,000,000. The effective annual interest rate on a loan
with a compensating balance when no interest is received on the compensating balance
is the annual interest due divided by the net funds the borrower will have available to
use. With a $5,000,000 compensating balance requirement on a $100,000,000 loan, the
borrower will have only $95,000,000 available to use.
Explanation for Choice D:
This is the stated interest rate plus the percentage of the total loan amount required to
be maintained as a compensating balance. This is not the correct way to calculate the
effective annual interest rate on a loan with a compensating balance requirement. The
effective annual interest rate on a loan with a compensating balance when no interest is
received on the compensating balance is the annual interest due divided by the net
funds the borrower will have available to use.
321. Question ID: ICMA 19.P2.085 (Topic: Short-term Bank Loans and Other S-T
Financing)
 Hock P2 2020
Section B - Corporate Finance.
Answers
A company has received a one-year commercial bank loan of 7.5% discounted interest
with a 12.5% compensating balance. The effective annual cost of the bank loan is
closest to

 A. 9.38%.correct
 B. 8.11%.
 C. 9.27%.
 D. 8.57%.
Question was not answered
Correct Answer Explanation:
The effective interest rate is calculated by dividing the amount of interest that will be
paid by the amount of new funds that the borrower has available after all withholdings of
the loan.
For this case, let us assume that the loan is a $1,000 loan. The borrower will pay 7.5%,
or $75 in interest. This $75 of interest will simply be withheld from the funds that are
given to the borrower, reducing the loan proceeds to $925.
In addition, the 12.5% compensating balance will reduce the available funds by $125,
reducing it to $800.
So, the borrower will pay $75 in interest and will have $800 of the loan available to
them. The effective interest is calculated as $75 / $800. The effective interest rate is
9.375%, which rounds to 9.38%
Explanation for Choice B:
This choice fails to reduce the amount of money available to the borrower by the
amount of the compensating balance. See the correct answer for a complete
explanation.
Explanation for Choice C:
This answer calculates the amount of the compensating balance after the interest has
been withheld. The compensating amount should be calculated using the face amount
of the loan. See the correct answer for a complete explanation.
Explanation for Choice D:
This choice fails to reduce the amount of money available to the borrower by the
amount of interest, which is withheld because it is discounted. See the correct answer
for a complete explanation.
322. Question ID: ICMA 10.P2.171 (Topic: Short-term Bank Loans and Other S-T
Financing)
 Hock P2 2020
Section B - Corporate Finance.
Answers
Burke Industries has a revolving credit arrangement with its bank which specifies that
Burke can borrow up to $5 million at an annual interest rate of 9% payable monthly. In
addition, Burke must pay a commitment fee of 0.25% per month on the unused portion
of the line, payable monthly. Burke expects to have a $2 million cash balance and no
borrowings against this line of credit on April 1, net cash inflows of $2 million in April, net
outflows of $7 million in May, and net inflows of $4 million in June. If all cash flows occur
at the end of the month, approximately how much will Burke pay to the bank during the
second quarter related to this revolving credit arrangement?

 A. $60,200.
 B. $52,600.correct
 C. $47,700.
 D. $62,500.
Question was not answered
Correct Answer Explanation:
During April and May, no amounts will be drawn on the line, so the company will owe
$12,500 (0.0025 × $5,000,000) for the full unused committed amount for each of those
two months, or $12,500 × 2 = $25,000.
On April 1, the company will begin the quarter with $2,000,000 in cash. Net April
inflows will be $2,000,000, minus the April commitment fee of $5,000,000 × 0.0025, or
$12,500, so the ending cash balance April 30 will be $3,987,500 ($2,000,000 +
$2,000,000 − $12,500).
Net May outflows will equal $7,000,000, but remember that these will not occur until the
end of the month. Therefore, the company will still have nothing outstanding on its line
until May 31 and will again owe a commitment fee for May equal to $5,000,000 ×
0.0025, or $12,500. So net outflows for May will be $7,000,000 + $12,500, or
$7,012,500. That will create a negative cash balance of $3,987,500 − $7,012,500, or
$(3,025,000), and the company will borrow that amount on its line of credit on May
31.
Net June inflows will equal $4,000,000. At the end of June, the company will owe 9%
interest on the amount outstanding on the line ($3,025,000) for one month; plus the
commitment fee of 0.0025 multiplied by the unused portion of the line. The unused
portion of the line will be $5,000,000 − $3,025,000, or $1,975,000. Therefore, the
commitment fee on the unused amount will be $1,975,000 × 0.0025, or $4,937.50.
Interest for one month is calculated by multiplying the outstanding amount of the loan by
9% (to get one year’s interest) and then dividing that by 12 (to convert that to one
month’s interest). Interest due for one month will be $3,025,000 × 0.09 ÷ 12, or
$22,687.50. So the total fees paid to the bank at the end of June for the month of June
will be $4,937.50 + $22,687.50, or $27,625.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Therefore, the total amount paid to the bank during the quarter will be $12,500 +
$12,500 + $27,625, or $52,625. The question asks approximately how much will
Burke pay to the bank. $52,625 is approximately $52,600.
Explanation for Choice A:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears in the upper right corner of the
ExamSuccess screen. Thank you in advance for helping us to make your HOCK study
materials better.
Explanation for Choice C:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice D:
This answer results from assuming that all cash flows occur at the beginning of each
month. However, the question says to assume that all cash flows occur at the end of the
month.
323. Question ID: CMA 1296 1.15 (Topic: Short-term Bank Loans and Other S-T
Financing)
The Frame Supply Company has just acquired a large account and needs to increase
its working capital by $100,000. The controller of the company has identified a number
of sources. One of them is:

 Borrow $110,000 from a bank at 12% interest. A 9% compensating balance would

be required.
 Assume a 360-day year in all of your calculations.
The cost of this alternative is:
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. 12.0%
 B. 9.0%
 C. 21.0%
 D. 13.2%correct
Question was not answered
Correct Answer Explanation:
When there is a compensating balance not all of the loaned funds are available to the
borrower. The bank retains the amount of the compensating balance, in this case
$9,900 ($110,000 × 0.09). This means that the borrower received only $100,100.
However, the 12% interest is paid on the full $110,000 amount of the loan. This is
$13,200 for one year ($1000,000 × 0.09). When we divide this by the cash received
from the loan, we get the effective annual interest rate of 13.2%.
Explanation for Choice A:
This is the nominal rate of interest. When there is a compensating balance the effective
rate of interest is higher than the nominal rate of interest, so this answer is not possible.
When there is a compensating balance not all of the loaned funds are available to the
borrower. The bank retains the amount of the compensating balance. However, the
interest is paid on the full amount of the loan. When we divide the interest paid for one
year by the cash received from the loan, we get the effective annual interest rate.
Explanation for Choice B:
This is the amount of the compensating balance requirement, not the effective annual
interest rate.
When there is a compensating balance not all of the loaned funds are available to the
borrower. The bank retains the amount of the compensating balance. However, the
interest is paid on the full amount of the loan. When we divide the interest paid for one
year by the cash received from the loan, we get the effective annual interest rate.
Explanation for Choice C:
This is the annual nominal rate of interest (12%) plus the compensating balance
requirement (9%), not the effective annual interest rate.
When there is a compensating balance not all of the loaned funds are available to the
borrower. The bank retains the amount of the compensating balance. However, the
interest is paid on the full amount of the loan. When we divide the interest paid for one
year by the cash received from the loan, we get the effective annual interest rate.
324. Question ID: ICMA 1603.P2.016 (Topic: Short-term Bank Loans and Other S-T
Financing)
 Hock P2 2020
Section B - Corporate Finance.
Answers
A commercial bank offered a $100,000 one-year loan with an annual interest rate of 6%
and a 10% compensating balance. What is the effective annual interest rate of this
loan?

 A. 6.00%.
 B. 6.67%.correct
 C. 5.45%.
 D. 7.00%.
Question was not answered
Correct Answer Explanation:
The loan amount is $100,000 at 6% interest, so interest for one year will be $6,000.
Because of the 10% compensating balance requirement, the borrower has the use of
only $90,000 of the loan proceeds. Therefore, the borrower's effective annual interest
rate on the loan is $6,000 ÷ $90,000, or 0.06667 which is 6.67%.
Explanation for Choice A:
This answer results from not reducing the balance of the loan that is available to the
borrower. Because of the compensating balance requirement, not all of the loan
proceeds will be available to the borrower, but the borrower will still be required to pay
interest on 100% of the loan. The balance of the loan available to the borrower should
be reduced to reflect the amount of the compensating balance that the borrower will not
be able to use.
Explanation for Choice C:
The effective annual interest rate of a loan with a compensating balance requirement
will never be lower than the nominal interest rate of the loan because the compensating
balance requirement decreases the amount of loan funds available to the borrower.
Decreasing the amount of loan funds available to the borrower increases the effective
annual interest rate on the loan above the nominal amount because the borrower is
paying interest on more funds than the borrower has available.
Explanation for Choice D:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID and the actual incorrect
answer choice—not its letter, because that can change with every study session
created. The Question ID appears at the top of the question. Thank you in advance for
helping us to make your HOCK study materials better.
 Hock P2 2020
Section B - Corporate Finance.
Answers
325. Question ID: CMA 1289 1.22 (Topic: Short-term Bank Loans and Other S-T
Financing)
The principal advantage of using commercial paper as a short-term financing instrument
is that it

 A. Is readily available to almost all companies.

 B. Is usually cheaper than a commercial bank loan.correct
 C. Can be purchased without commission costs.
 D. Offers security, i.e., collateral, to the lender.
Question was not answered
Correct Answer Explanation:
Commercial paper is an unsecured note that is issued only by the largest, most stable
and credit-worthy companies. Commercial paper is sold at a discount and usually is
very short-term. Usually, commercial paper is cheaper than a bank loan because the
nature of the companies that are able to issue commercial paper greatly reduces the
risk to the investor.
Explanation for Choice A:
Commercial paper is an unsecured note that is able to be issued only by the largest,
most credit-worthy companies. Therefore, it is not a source of financing for most
companies.
Explanation for Choice C:
Generally a commission is charged on commercial paper just as on other instruments.
Explanation for Choice D:
Commercial paper is an unsecured note so there is no collateral available to the
investor in the case of default by the issuer.
326. Question ID: ICMA 10.P2.150 (Topic: Short-term Bank Loans and Other S-T
Financing)
The Duoplan Company is determining the most appropriate source of short-term
funding. Trade credit terms from suppliers are 2/30, net 90. The rate for borrowing at the
bank is 12%. The company has also been approached by an investment banker offering
to issue Duoplan's commercial paper. The commercial paper would be issued quarterly
in increments of $9.1 million with net proceeds of $8.8 million. Which option should the
firm select?

 A. The trade discount, because it provides the lowest cost of funds.

 B. The costs are so similar that the decision is a matter of convenience.
 C. Bank borrowing, because it provides the lowest cost of funds.correct
 Hock P2 2020
Section B - Corporate Finance.
Answers
 D. Commercial paper, because it provides the lowest cost of funds.
Question was not answered
Correct Answer Explanation:
The way to solve this is to calculate the effective annual percentage rate of each of the
three types of borrowing.
Commercial paper: The commercial paper is issued quarterly. The question does not
state when each commercial paper issuance is due, so we must assume that each one
will be paid off by the next one, that is, in 3 months. Therefore, the amount outstanding
for one year will be a continuous amount of $8,800,000. The amount of interest that will
be payable each quarter for that outstanding balance will be the difference between
$9.1 million and $8.8 million, which is $300,000. To convert that quarterly interest
payment to an annual interest amount, we multiply it by 4. The annual interest due will
thus be $1,200,000. So the annual percentage rate for the commercial paper will be
$1,200,000 ÷ $8,800,000, which is 13.64%.
Bank: This rate is given as 12%.
Suppliers: The formula to calculate the cost of not taking a supplier’s discount is:

360 Discount %
×
Total period for payment − Period for discount payment 100% − Discount %
Duoplan's cost of trade credit is:

360 0.02
× =
90 − 30 1.00 − 0.02
6 × 0.020408 = 0.1224 or 12.24%.
In comparing the cost of any source of funding with the cost of not taking a discount, the
assumption is that the company would use the borrowed funds to take the discount on
the trade credit, thereby avoiding the high cost of not taking the discount. If the
company does not do that, then it will end up paying interest in both places.
So assuming Duoplan will borrow from the bank and use the borrowed funds to take the
suppliers' discounts, the bank’s rate is the lowest of the three.
Explanation for Choice A:
The formula to calculate the cost of not taking a supplier's discount is:

360 Discount %
×
Total period for payment − Period for discount payment 100% − Discount %
Duoplan's cost of trade credit is:
 Hock P2 2020
Section B - Corporate Finance.
Answers
360 0.02
× =
90 − 30 1.00 − 0.02
6 × 0.020408 = 0.1224 or 12.24%.
This is not the lowest available cost of funds.
Explanation for Choice B:
The rates on the three options are different enough that, based on the outstanding
borrowings, the difference in the interest costs will be significant.
Explanation for Choice D:
The commercial paper is issued quarterly. The question does not state when each
commercial paper issuance is due, so we must assume that each one will be paid off by
the next one, that is, in 3 months. Therefore, the amount outstanding for one year will
be a continuous amount of $8,800,000. The amount of interest that will be payable each
quarter for that outstanding balance will be the difference between $9.1 million and $8.8
million, which is $300,000. To convert that quarterly interest payment to an annual
interest amount, we multiply it by 4. The annual interest due will thus be $1,200,000. So
the annual percentage rate for the commercial paper will be $1,200,000 ÷ $8,800,000,
which is 13.64%. This is not the lowest available cost of funds.
327. Question ID: CMA 1296 1.17 (Topic: Short-term Bank Loans and Other S-T
Financing)
The Frame Supply Company has just acquired a large account and needs to increase
its working capital by $100,000. The controller of the company has identified a number
of sources. One of them is:

 Borrow $125,000 from a bank on a discount basis for one year at 20%. No
compensating balance would be required.
 Assume a 360-day year in all of your calculations.
The cost of this alternative is:

 A. 20.0%
 B. 40.0%
 C. 25.0%correct
 D. 50.0%
Question was not answered
Correct Answer Explanation:
When a loan is discounted, the bank withholds the amount of the interest from the
proceeds that are loaned. But when the loan becomes due the borrower needs to repay
the full face amount of the loan. In this loan, the interest is $25,000. This is withheld
 Hock P2 2020
Section B - Corporate Finance.
Answers
from the proceeds of the loan and Frame will receive only $100,000. The amount they
will need to repay is $125,000, which includes $25,000 in interest. Given the proceeds
of $100,000, the effective interest rate is 25%.
Explanation for Choice A:
This is the nominal rate of interest. When there is discounted interest the effective rate
of interest is higher than the nominal rate of interest, so this answer is not possible.
When a loan is discounted, the bank withholds the amount of the interest from the
proceeds that are loaned. But when the loan becomes due the borrower needs to repay
the full face amount of the loan. The difference is the interest. The effective annual rate
is the interest paid for one year divided by the net proceeds of the loan that is
outstanding during the year.
Explanation for Choice B:
This is the discount rate multiplied by 2. When a loan is discounted, the bank withholds
the amount of the interest from the proceeds that are loaned. But when the loan
becomes due the borrower needs to repay the full face amount of the loan. The
difference is the interest. The effective annual rate is the interest paid for one year
divided by the net proceeds of the loan that is outstanding during the year.
Explanation for Choice D:
This is the amount of interest paid for one year multiplied by 2, the product divided by
the net proceeds of the loan. The effective annual rate is the interest paid for one year
divided by the net proceeds of the loan that is outstanding during the year.
328. Question ID: CMA Sample Q1.7 (Topic: Short-term Bank Loans and Other S-T
Financing)
On January 1, Scott Corporation received a $300,000 line of credit at an interest rate of
12% from Main Street Bank and drew down the entire amount on February 1. The line
of credit agreement requires that an amount equal to 15% of the loan be deposited into
a compensating balance account. What is the effective annual cost of credit for this loan
arrangement?

 A. 12.94%
 B. 14.12%correct
 C. 12.00%
 D. 11.00%
Question was not answered
Correct Answer Explanation:
In a loan with a compensating balance the borrower does not actually receive all of the
monies that are loaned because they must keep on deposit with the bank some of the
money as the compensating balance. However, they must pay interest on the full
 Hock P2 2020
Section B - Corporate Finance.
Answers
amount of the loan. Therefore, Scott will pay $36,000 in interest but will receive only
$255,000. This makes the effective interest rate 14.12% ($36,000 ÷ $255,000).
Explanation for Choice A:
This answer takes into account only 11 months of interest. However, the question asks
for the effective annual rate. The effective annual rate assumes that the balance that
was outstanding on the loan for part of the year was outstanding for the full year, so we
need to use 12 months of interest. See the correct answer for a complete explanation.
Explanation for Choice C:
This is the stated interest rate on the loan. In a loan with a compensating balance the
borrower does not actually receive all of the monies that are loaned because they must
keep on deposit with the bank some of the money as the compensating balance.
However, they must pay interest on the full amount of the loan. Because of this the
effective interest rate on the loan is higher than the stated (or nominal) rate of the loan.
See the correct answer for a complete explanation.
Explanation for Choice D:
In a loan with a compensating balance the borrower does not actually receive all of the
monies that are loaned because they must keep on deposit with the bank some of the
money as the compensating balance. However, they must pay interest on the full
amount of the loan. Because of this the effective interest rate on the loan is higher than
the stated (or nominal) rate of the loan. This rate is lower. See the correct answer for a
complete explanation.
329. Question ID: CMA 1295 1.11 (Topic: Short-term Bank Loans and Other S-T
Financing)
Elan Corporation is considering borrowing $100,000 from a bank for 1 year at a stated
interest rate of 9%. What is the effective interest rate to Elan if this borrowing is in the
form of a discounted note?

 A. 9.00%
 B. 8.19%
 C. 9.89%correct
 D. 9.81%
Question was not answered
Correct Answer Explanation:
When interest is discounted, the amount that will be incurred as interest is withheld from
the loan proceeds given to the borrower. So, in this loan, the interest will be $9,000.
However, instead of receiving $100,000 and repaying $109,000, the bank withholds the
interest and disburses only $91,000, while getting $100,000 when the loan matures.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Therefore, the effective rate is 9.89% since the interest expense is $9,000, but only
$91,000 of funds were received.
Explanation for Choice A:
This is the nominal rate on the loan. When there is discounted interest, the effective rate
is always higher than the nominal rate, because the interest is withheld from the
proceeds of the loan, and the borrower must repay the full face value of the note,
including the interest.
Explanation for Choice B:
This answer results from decreasing the loan amount by $9,000 in interest, then
multiplying the remaining $91,000 by 9%, which equals $8,190. $8,190 divided by
$100,000 is 8.19%. This is incorrect for two reasons: (1) The amount of interest in the
numerator should be $9,000, not $8,190. And (2) The denominator should be the net
proceeds received by the borrower, which is $91,000, not $100,000.
Explanation for Choice D:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
330. Question ID: CMA 694 1.21 (Topic: Short-term Bank Loans and Other S-T
Financing)
A company obtained a short-term bank loan of $500,000 at an annual interest rate of
8%. As a condition of the loan, the company is required to maintain a compensating
balance of $100,000 in its checking account. The checking account earns interest at an
annual rate of 3%. Ordinarily, the company maintains a balance of $50,000 in its
account for transaction purposes. What is the effective interest rate of the loan?

 A. 7.77%
 B. 8.22%
 C. 9.25%
 D. 8.56%correct
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
In order to calculate the effective interest rate we need to determine how much the
company will pay for interest on the loan and how much they will receive from the bank
in interest on their deposit. The amount of the loan is $500,000, but with a
compensating balance requirement of $100,000, they will not receive this entire amount.
The compensating balance is $100,000, but since they already have $50,000 in the
bank, they need to add only $50,000 of the loan proceeds to the balance to reach the
required level. They will receive, then, in essence, $450,000 from the bank. They will
need to pay interest, however, on the entire $500,000. At 8% this is $40,000 per year.
However, they will also earn 3% on the $50,000 they added to their bank balance. This
$1,500 is offset against the interest paid, giving a total interest expense of $38,500. So,
the effective interest rate is 8.56% ($38,500 ÷ $450,000).
Explanation for Choice A:
Since there is a compensating balance in the loan, the effective interest rate must be
higher than the stated rate of 8%. Therefore, this answer is not possible. See the correct
answer for a complete explanation.
Explanation for Choice B:
This answer results from dividing net interest of $37,000 by an available loan balance of
$450,000. However, the net interest of $37,000 results from assuming that 3% will be
earned on the compensating deposit in the amount of $100,000. The question says that
the company ordinarily maintains a balance of $50,000 in its account for transaction
purposes. Therefore, only $50,000 of the loan proceeds will be added to the checking
account, and the incremental amount of interest earned will be 3% of $50,000.
Explanation for Choice C:
This answer results from assuming that $100,000 of the loan proceeds will be
unavailable to the company because it will be required as the compensating balance.
However, the question says that the company ordinarily maintains a balance of $50,000
in its account for transaction purposes. Therefore, only $50,000 of the loan proceeds
will be added to the checking account and will be unavailable to the company.
This will affect the calculation of the net interest expense (because the interest earned
on the deposit will be based on the $50,000 added to the account, not the full $100,000
requirement) as well as the available funds from the loan.
331. Question ID: ICMA 10.P2.176 (Topic: Short-term Bank Loans and Other S-T
Financing)
Megatech Inc. is a large publicly-held firm. The treasurer is making an analysis of the
short-term financing options available for the third quarter, as the company will need an
average of $8 million for the month of July, $12 million for August, and $10 million for
September. The following options are available.
 Hock P2 2020
Section B - Corporate Finance.
Answers
I. Issue commercial paper on July 1 in an amount sufficient to net Megatech $12 million at
an effective rate of 7% per year. Any temporarily excess funds will be deposited in
Megatech's investment account at First City Bank and earn interest at an annual rate of
4%.
II. Utilize a line of credit from First City Bank with interest accruing monthly on the amount
utilized at the prime rate, which is estimated to be 8% in July and August and 8.5% in
September.
Based on this information, which one of the following actions should the treasurer take?

 A. Use the line of credit, since it is approximately $15,000 less expensive than issuing
commercial paper.
 B. Issue commercial paper, since it is approximately $14,200 less expensive than the line
of credit.correct
 C. Issue commercial paper, since it is approximately $35,000 less expensive than the line
of credit.
 D. Use the line of credit, since it is approximately $5,800 less expensive than issuing
commercial paper.
Question was not answered
Correct Answer Explanation:
Megatech will need $8 million in additional cash in July. In August, the company will
need an additional $4 million in cash, for a total of $12 million needed. In September,
the company's cash need will decrease to $10 million.
If the company utilizes commercial paper, it will receive $12 million at the beginning of
July and will pay interest on the full $12 million during July, August, and September; but
during July and September, it will be able to invest the amounts it does not need for
operations: $4 million during July and $2 million during September.
If the company utilizes the bank line of credit, it will pay interest on only the amounts
outstanding, which will be $8 million during July, $12 million during August, and $10
million during September.

The net cost of the commercial paper (interest cost less interest income) is:
Gross cost: $12,000,000 × 0.07 ÷ 12 months × 3 months = $210,000
Total income from investing unneeded funds (income amounts are in parentheses
because they reduce the cost):
July: $4,000,000 invested × 0.04 ÷ 12 months = $(13,333)
August: No unneeded funds to invest = 0
September: $2,000,000 invested × 0.04 ÷ 12 months = $(6,667)
 Hock P2 2020
Section B - Corporate Finance.
Answers
Net cost of commercial paper = $210,000 − $13,333 − $6,667 = $190,000
The cost of the line of credit is:
July: $8,000,000 borrowed × 0.08 ÷ 12 months = $53,333
August: $12,000,000 borrowed × 0.08 ÷ 12 = $80,000
September: $10,000,000 borrowed × 0.085 ÷ 12 = $70,833
Total cost of the line of credit = $53,333 + $80,000 + $70,833 = $204,166
Difference in cost:
$204,166 for the line of credit − $190,000 for the commercial paper = $14,166
The commercial paper is $14,166 less expensive than the cost of the line of credit, so
the company should issue commercial paper, since commercial paper is approximately
$14,200 less expensive than the line of credit.
Explanation for Choice A:
This is not the correct answer. Please see the correct answer for a complete
explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice C:
This answer results from two mistakes: (1) using an outstanding balance of $12 million
on the line of credit for the full three months in calculating the interest expense charged
on the line. The amount outstanding on the line each month will be only the amount that
Megatech needs that month, and those are the balances that interest will be calculated
on. (2) not accounting for the interest income that can be earned by investing unneeded
funds from the issuance of the commercial paper.
Explanation for Choice D:
This answer results from not accounting for the interest income that can be earned by
investing unneeded funds from the issuance of the commercial paper.
332. Question ID: ICMA 10.P2.183 (Topic: Short-term Bank Loans and Other S-T
Financing)
The effective annual interest rate to the borrower of a $100,000 one-year loan with a
stated rate of 7% and a 20% compensating balance is
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. 7.0%.
 B. 13.0%.
 C. 8.4%.
 D. 8.75%.correct
Question was not answered
Correct Answer Explanation:
The annual interest on $100,000 at a stated interest rate of 7% is $7,000 ($100,000 ×
0.07). The net available funds to the borrower if a 20% compensating balance is
required is 80% of $100,000, or $80,000. The effective annual interest rate on a loan
with a compensating balance when no interest is received on the compensating balance
is the annual interest due divided by the net funds the borrower will have available to
use. Thus the effective annual interest rate on the loan is $7,000 ÷ $80,000, which
equals 0.0875 or 8.75%.
Explanation for Choice A:
7.0% is the stated interest rate on the loan. Because the borrower has a compensating
balance requirement, not all of the loan proceeds will be available to the borrower to
use. The effective annual interest rate on a loan with a compensating balance when no
interest is received on the compensating balance is the annual interest due divided by
the net funds the borrower will have available to use, and it is different from the stated
interest rate.
Explanation for Choice B:
This is 20% minus 7%. That is not the correct way to find the answer to this question.
The correct way to calculate the effective annual rate on this loan is to first calculate the
annual interest that will be due on $100,000 at a stated rate of 7% for one year. Then,
find the net funds from the loan the borrower will have available after deducting the
compensating balance requirement. The effective annual interest rate on a loan with a
compensating balance when no interest is received on the compensating balance is the
annual interest due divided by the net funds the borrower will have available to use.
Explanation for Choice C:
This is 7% × 1.20. This is not the correct way to find the answer to this question.
The correct way to calculate the effective annual rate on this loan is to first calculate the
annual interest that will be due on $100,000 at a stated rate of 7% for one year. Then,
find the net funds from the loan the borrower will have available after deducting the
compensating balance requirement. The effective annual interest rate on a loan with a
compensating balance when no interest is received on the compensating balance is the
annual interest due divided by the net funds the borrower will have available to use.
 Hock P2 2020
Section B - Corporate Finance.
Answers
333. Question ID: CMA 1290 1.28 (Topic: Short-term Bank Loans and Other S-T
Financing)
Corbin, Inc. can issue 3-month commercial paper with a face value of $1,000,000 for
$980,000. Transaction costs will be $1,200. The effective annualized percentage cost of
the financing, based on a 360-day year, will be

 A. 8.66%.correct
 B. 8.17%.
 C. 2.00%.
 D. 8.00%.
Question was not answered
Correct Answer Explanation:
The effective annual interest rate on a security or loan is calculated by calculating the
cost for the holding period (including discounted interest or other costs), annualizing it,
and dividing the annualized cost by the average balance outstanding for the period,
which in this case is the amount of cash actually received.
The cost for 90 days will be $21,200, consisting of the $20,000 discount that is given to
sell the paper and the $1,200 transaction cost. Corbin will receive only $978,800 from
this issuance, so the effective cost for 90 days is $21,200. However, this is the cost for
only 90 days, so it must be annualized by dividing it by the number of days (90) to find
the cost per day and multiplying the cost per day by 360 to find the cost for a full year.
$21,200 ÷ 90 × 360 = $84,800.
The annual cost is then divided by the average balance outstanding, which in this case
is $978,800. $84,800 ÷ $978,800 = 0.0866 or 8.66%.
Explanation for Choice B:
This answer does not include the $1,200 of transaction costs, which must be included
as a cost to Corbin. See the correct answer for a complete explanation.
Explanation for Choice C:
This is the stated rate for three months. See the correct answer for a complete
explanation.
Explanation for Choice D:
This answer does not include the $1,200 of transaction costs, which must be included
as a cost to Corbin and it considers that all of the $1,000,000 face amount was received
by Corbin. See the correct answer for a complete explanation.
334. Question ID: ICMA 10.P2.179 (Topic: Short-term Bank Loans and Other S-T
Financing)
 Hock P2 2020
Section B - Corporate Finance.
Answers
Lang National Bank offered a one-year loan to a commercial customer. The instrument
is a discounted note with a nominal rate of 12%. What is the effective interest rate to the
borrower?

 A. 13.64%correct
 B. 10.71%
 C. 12.00%
 D. 13.20%
Question was not answered
Correct Answer Explanation:
The easiest way to approach a question like this is to make up some numbers. So we
will say that the loan amount is $100,000. It is a discounted note, which means that the
interest is subtracted from the proceeds of the loan (the amount of money the borrower
actually receives), and the borrower must pay back the entire $100,000. So 12% of
$100,000, or $12,000, will be subtracted from the proceeds, and the borrower will
receive $88,000. The borrower will be obligated to repay the full amount of the note,
which will consist of the $88,000 loan proceeds plus the $12,000 interest, for a total of
$100,000. Therefore, the effective interest rate will be $12,000 ÷ $88,000 = 0.1364 or
13.64%.
Another way to calculate this answer is simply to divide 0.12 by (1 − 0.12):
0.12 ÷ 0.88 = 0.1364 or 13.64%.
Explanation for Choice B:
The easiest way to approach a question like this is to make up a gross amount for the
loan and multiply it by the nominal rate to calculate the amount of the discounted
interest. Then subtract the amount of the discounted interest from the gross amount of
the loan to calculate the amount of the proceeds of the loan. Finally, divide the amount
of the annual interest by the amount of the proceeds of the loan. Since in this question
the loan is for one year, the amount of the annual interest is the same as the amount of
the discounted interest. (If the loan were for a period other than one year, it would be
necessary to annualize the amount of the discounted interest.)
This answer results from adding the amount of the discounted interest to the gross
amount for the loan to get the amount of the proceeds for the loan, instead of
subtracting it. Or, it may result from dividing 0.12 by (1 + the nominal rate of 0.12).
Explanation for Choice C:
12% is the nominal interest rate on a discounted note. The question is asking for the
effective interest rate. The effective annual interest rate is the amount of interest paid for
a year divided by the proceeds of the loan (the amount the borrower actually receives).
 Hock P2 2020
Section B - Corporate Finance.
Answers
The amount the borrower actually receives will be the face amount of the note minus
the discounted interest amount.
Explanation for Choice D:
This answer results from dividing 0.12 by the present value of $1 factor for 10% for 1
year. The easiest way to approach a question like this is to make up a gross amount for
the loan and multiply it by the nominal rate to calculate the amount of the discounted
interest. Then subtract the amount of the discounted interest from the gross amount of
the loan to calculate the amount of the proceeds of the loan. Finally, divide the amount
of the annual interest by the amount of the proceeds of the loan. Since in this question
the loan is for one year, the amount of the annual interest is the same as the amount of
the discounted interest. (If the loan were for a period other than one year, it would be
necessary to annualize the amount of the discounted interest.)
335. Question ID: ICMA 10.P2.180 (Topic: Short-term Bank Loans and Other S-T
Financing)
Gates Inc. has been offered a one-year loan by its commercial bank. The instrument is
a discounted note with a stated interest rate of 9%. If Gates needs $300,000 for use in
the business, what should the face value of the note be?

 A. $275,229.
 B. $327,000.
 C. $329,670.correct
 D. $327,154.
Question was not answered
Correct Answer Explanation:
This is a discounted note, which means that the interest is calculated on the gross
amount of the note, and the interest is subtracted from the gross amount to find the
amount the borrower actually receives. However, the borrower must pay back the entire
gross amount, including the interest.
If the discount rate is 9%, 9% of the gross loan amount will be subtracted from the face
amount of the note to determine the amount the borrower will receive. Gates needs
$300,000. Therefore, the formula we will use to find the face amount of the note will be:
X − 0.09X = $300,000
Where X = the face amount of the note
Simplifying that equation, we get:
0.91X = $300,000
Solving for X, we get X = $329,670; and that is the amount that Gates will need to
borrow in order to receive a net amount of $300,000 from the loan disbursement.
 Hock P2 2020
Section B - Corporate Finance.
Answers
To prove that answer: $329,670 × 0.09 = $29,670.
$329,670 − $29,670 = $300,000, the net disbursement the borrower needs to receive.
Explanation for Choice A:
This is $300,000 ÷ 1.09. This is not a reasonable answer to the question.
This is a discounted note, which means that the interest is calculated on the gross
amount of the note, and the interest is subtracted from the gross amount to find the
amount the borrower actually receives. However, the borrower must pay back the entire
gross amount, including the interest.
If the net proceeds of the note needs to be $300,000 and interest is subtracted from the
face amount to calculate the net proceeds, the face amount of the note must
be greater than the $300,000 net proceeds needed. This amount is less than the
$300,000 net proceeds needed.
Explanation for Choice B:
This is a discounted note, which means that the interest is calculated on the gross
amount of the note, and the interest is subtracted from the gross amount to find the
amount the borrower actually receives. However, the borrower must pay back the entire
gross amount, including the interest.
This is $300,000 × 1.09. Multiplying by 1.09 effectively calculates 9% of $300,000 and
adds that to $300,000. However, $300,000 is what the net proceeds of the loan needs
to be after the discounted interest has been subtracted from the face amount of the
note. The bank will calculate the 9% discounted interest on the face amount (the gross
amount) of the note instead.
Explanation for Choice D:
This is $300,000 ÷ 0.917, the present value of $1 factor for 9% for one year.
The present value of a given amount (here unknown) is the amount an investor could
invest today at the given interest rate (here 9%) if the investor had it, and with the
interest added, it would grow to the given amount in the given amount of time (here one
year). That is not the situation here.
This is a discounted note, which means that the interest is calculated on the gross
amount of the note, and the interest is subtracted from the gross amount to find the
amount the borrower actually receives. However, the borrower must pay back the entire
gross amount, including the interest. The usual type of interest calculation will not work
in this situation, because of the fact that the interest amount paid by the borrower is not
based on the amount the borrower receives.
In fact, the effective rate of interest on a loan like this is higher than its stated rate
because the borrower has to pay interest on a principal amount that is greater than the
amount the borrower receives. If the effective interest rate were known, dividing
 Hock P2 2020
Section B - Corporate Finance.
Answers
$300,000 by the factor for that interest rate would result in the correct answer. But the
effective interest rate on the loan cannot be calculated until the correct answer to this
question has been calculated and the interest amount is known. So dividing $300,000
by the factor for the effective interest rate cannot be used to find the answer to this
problem, either.
336. Question ID: CMA 697 1.15 (Topic: Short-term Bank Loans and Other S-T
Financing)
The treasury analyst for Garth Manufacturing has estimated the cash flows for the first
half of next year (ignoring any short-term borrowings) as follows.

Cash (millions)
Inflows Outflows
January $2 $1
February 2 4
March 2 5
April 2 3
May 4 2
June 5 3
Garth has a line of credit of up to $4 million on which it pays interest monthly at a rate of
1% of the amount utilized. Garth is expected to have a cash balance of $2 million on
January 1 and no amount utilized on its line of credit. Assuming all cash flows occur at
the end of the month, approximately how much will Garth pay in interest during the first
half of the year?

 A. $132,000
 B. $61,000correct
 C. Zero.
 D. $80,000
Question was not answered
Correct Answer Explanation:
Garth will not need to borrow anything until the end of March because that is the first
date when the cash balance will be negative without borrowing.
At the end of March, Garth will need to borrow $2,000,000 to get its cash balance up to
zero. That $2,000,000 will be outstanding during the month of April, since the question
says that all cash flows occur at the end of each month.
 Hock P2 2020
Section B - Corporate Finance.
Answers
For the month of April, that $2,000,000 outstanding on the line of credit will incur
$20,000 of interest, so that interest will become an additional cash outflow at the end of
April, making the required loan balance at the end of April $3,020,000. Cash in for April
is $2,000,000 and cash out for April is $3,000,000 + $20,000 interest; so Garth will need
to borrow another $1,000,000 as well as the amount due for interest. The ending cash
balance for April will be $0 + $2,000,000 cash inflow from operations − $3,000,000 cash
outflow from operations − $20,000 interest = $(1,020,000). So Garth will add that to its
outstanding loan balance of $2,000,000.
$3,020,000 will be outstanding on the loan during the month of May, and interest due at
the end of May on the outstanding balance will be $30,200.
For the month of May, cash inflow is $4,000,000 from operations and cash outflow is
$2,000,000 from operations plus the cash paid in interest of $30,200. Ending cash
balance before any loans are repaid will be $1,969,800. So the company will be able to
pay down $1,969,800 on the line of credit at the end of May.
The amount of the loan outstanding at the end of May will be $1,050,200 ($3,020,000 −
$1,969,800). So interest accrued on the loan outstanding during the month of June will
be $10,502.
In June, $5,000,000 of cash from operations comes in and only $3,000,000 cash from
operations goes out, plus the cash paid in interest of $10,502. At the end of the month,
before any loan repayment is made, the company will have $5,000,000 − $3,000,000 −
$10,502, or $1,989,498. The company will be able to pay off the entire principal
outstanding on its line of credit of $1,050,200 at the end of June and will have $939,298
in cash left.
So the total interest paid for the first half of the year will be: $20,000 paid at the end of
April + $30,200 paid at the end of May + $10,502 paid at the end of June, for a total of
$60,702. Since the question asks for the approximate amount of interest paid during
the first half of the year, $61,000 is the closest answer.
Explanation for Choice A:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice C:
This answer could result from simply summing the beginning cash balance and the
expected inflows and subtracting the expected outflows. However, timing of the cash
 Hock P2 2020
Section B - Corporate Finance.
Answers
flows is important in determining the need for financing, and financing will be needed, so
interest expense will be greater than zero.
Explanation for Choice D:
This is not the correct answer. Please see the correct answer for an explanation.
We have been unable to determine how to calculate this incorrect answer choice. If you
have calculated it, please let us know how you did it so we can create a full explanation
of why this answer choice is incorrect. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
337. Question ID: CMA 1289 1.21 (Topic: Short-term Bank Loans and Other S-T
Financing)
The Altmane Corporation was recently quoted terms on a commercial bank loan of 7%
discounted interest with a 20% compensating balance. The term of the loan is 1 year.
The effective cost of borrowing is (rounded to the nearest hundredth)

 A. 9.59%.correct
 B. 8.75%.
 C. 7.53%.
 D. 9.41%.
Question was not answered
Correct Answer Explanation:
In this question we have two different adjustments that need to be made in order to
calculate the effective interest rate. Also, in this question they do not give us an amount
for the loan, so let us assume that the loan is $100. The two adjustments are the 7%
discounted interest and the compensating balance. Both of these will reduce the
proceeds actually received from the loan. The 7% interest is withheld at the inception of
the loan and this amounts to $7, reducing the proceeds to $93. However, the 20%
compensating balance will also reduce the proceeds. The compensating balance is
calculated on the gross amount of the loan ($100), and 20% of $100 is $20. Therefore,
the compensating balance plus the discount amount bring the proceeds down to $73.
The interest owed for one year is $7, but the proceeds are really only $73. This gives an
effective rate of 9.59% ($7 ÷ $73).
Explanation for Choice B:
This answer does not treat the interest as discounted interest. Because the interest is
discounted, it should be subtracted at the beginning of the loan to calculate the
proceeds from the loan. See the correct answer for a complete explanation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice C:
This answer does not include the compensating balance, which reduces the amount of
money received as proceeds from the loan. See the correct answer for a complete
explanation.
Explanation for Choice D:
This answer results from calculating the compensating balance by multiplying the
discounted proceeds of the loan by 20%. Assuming a loan amount of $100, this answer
results from dividing the interest ($7) by [($100 − $7) − ($93 × 0.20)], or $7 ÷ $74.40,
which equals 9.41%.
The compensating balance should be 20% of the gross loan balance, not 20% of the
discounted loan balance. The divisor should be [($100 − $7) − ($100 × 0.20)], or $73.
338. Question ID: ICMA 10.P2.181 (Topic: Short-term Bank Loans and Other S-T
Financing)
Keller Products needs $150,000 of additional funds over the next year in order to satisfy
a significant increase in demand. A commercial bank has offered Keller a one-year loan
at a nominal rate of 8%, which requires a 15% compensating balance. How much
would Keller have to borrow, assuming it would need to cover the compensating
balance with the loan proceeds?

 A. $176,471.correct
 B. $130,435.
 C. $194,805.
 D. $172,500.
Question was not answered
Correct Answer Explanation:
Let X represent the amount of the loan and 0.15X represent the amount of the
compensating deposit. We need X (the amount of the loan) minus 0.15X (the amount of
the compensating deposit) to be equal to $150,000. The equation and its solution are:
X − 0.15X = $150,000
0.85X = $150,000
X = $176,471
The problem could also be solved by dividing $150,000 by 0.85 (1.00 − 0.15). $150,000
÷ 0.85 = $176,471.
Explanation for Choice B:
This is $150,000 ÷ 1.15. The resulting amount is not a reasonable answer to the
question.
 Hock P2 2020
Section B - Corporate Finance.
Answers
A portion of the loan proceeds will not be available to Keller, because it will be used to
cover the compensating deposit requirement. Therefore, Keller will have to
borrow more than $150,000 in order to have $150,000 available after subtracting 15%
of the loan amount. $130,435 is less than $150,000, so a loan of $130,435 amount
could not possibly provide the funds Keller needs and the funds to cover the
compensating deposit required.
Explanation for Choice C:
This is $150,000 ÷ 0.77. This would be correct if this were a discounted note,
discounted at its interest rate of 8% and neither the interest amount nor the
compensating balance required were available to the borrower. However, this is not a
discounted note. Only the compensating balance required will not be available to the
borrower.
Explanation for Choice D:
This is $150,000 × 1.15. Multiplying by 1.15 effectively calculates 15% of $150,000 and
adds that to $150,000. However, $150,000 is how much Keller needs from the loan. The
bank will calculate the amount of the compensating balance requirement on the amount
borrowed instead. The amount borrowed will need to include the compensating balance
requirement.
339. Question ID: CMA 1295 1.10 (Topic: Short-term Bank Loans and Other S-T
Financing)
The Dixon Corporation has an outstanding 1-year bank loan of $300,000 at a stated
interest rate of 8%. In addition, Dixon is required to maintain a 20% compensating
balance in its checking account. Assuming the company would normally maintain a zero
balance in its checking account, the effective interest rate on the loan is

 A. 6.4%
 B. 10.0%correct
 C. 8.0%
 D. 20.0%
Question was not answered
Correct Answer Explanation:
When there is a compensating balance, interest is paid on the entire amount of the loan,
but not all of the loan amount is available to the borrower. The interest paid is 8% of
$300,000, or $24,000. Because of the compensating balance, only $240,000 of loan
proceeds are available to use. Dividing the interest to be paid of $24,000 by the
available funds gives us the effective interest rate of 10%.
Explanation for Choice A:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This answer results from dividing $19,200 by $300,000, the gross amount of the loan.
$19,200 is 8% of $240,000, the net amount of usable funds after the 20% compensating
balance is subtracted. This is incorrect for two reasons: (1) The numerator should be
8% of the gross amount of $300,000. And (2) the denominator should be
the net amount of usable funds, not the gross amount of the loan.
Explanation for Choice C:
This answer is the nominal rate of interest, not the effective rate of interest. See the
correct answer for a complete explanation.
Explanation for Choice D:
This is the percentage of the loan amount that must be kept in a compensating balance
account and is not available to use. It is not the effective rate of interest on the loan.
340. Question ID: ICMA 1603.P2.013 (Topic: Short-term Bank Loans and Other S-T
Financing)
A company had total sales of $500,000 in the first quarter of the year, which was the
same amount as it recorded in the first quarter of the prior year. However, its accounts
receivable balance increased from $230,000 last year to $300,000 this year. Which one
of the following is the most likely explanation for the increase in the accounts receivable
balance?

 A. The company discontinued the use of factoring in the current year.correct

 B. The company initiated the use of factoring in the current year.
 C. The company shortened its payment terms in the current year from 60 days to 30 days.
 D. The company hired more people in its credit and collections department.
Question was not answered
Correct Answer Explanation:
Discontinuing the use of factoring would cause the accounts receivable balance to
increase because the company would be carrying more of its own accounts receivable
on its balance sheet instead of selling the receivables.
Explanation for Choice B:
If the company had initiated the use of factoring in the current year, the accounts
receivable balance would be expected to decline, not increase.
Explanation for Choice C:
Shortening its payment terms would not cause the company's accounts receivable to
increase.
Explanation for Choice D:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Hiring more people in its credit and collections department would not cause the
company's accounts receivable to increase.
341. Question ID: CMA 697 1.19 (Topic: Short-term Bank Loans and Other S-T
Financing)
Hagar Company's bank requires a compensating balance of 20% on a $100,000 loan. If
the stated interest on the loan is 7%, what is the effective cost of the loan?

 A. 5.83%
 B. 8.40%
 C. 7.00%
 D. 8.75%correct
Question was not answered
Correct Answer Explanation:
In a loan with a compensating balance the borrower does not actually receive all of the
monies that are loaned because they must keep on deposit with the bank some of the
money as the compensating balance. However, they must pay interest on the full
amount of the loan. Therefore, Hagar will pay $7,000 in interest (7% of $100,000) but
will have use of only $80,000. The interest payable divided by the usable funds equals
the effective annual rate. The effective interest rate is 8.75% ($7,000 ÷ $80,000).
Explanation for Choice A:
This is the interest on $100,000 at 7% divided by the amount of the loan plus the
compensating balance. In a loan with a compensating balance the borrower does not
actually receive all of the monies that are loaned because they must keep on deposit
with the bank some of the money as the compensating balance. However, they must
pay interest on the full amount of the loan. Because of this the effective interest rate on
the loan is higher than the stated (or nominal) rate of the loan. The interest payable
divided by the usable funds equals the effective annual rate.
Explanation for Choice B:
This answer results from increasing the amount of interest due for one year by 20% and
dividing the result by $100,000. This is not the way a compensating balance
requirement works. In a loan with a compensating balance requirement, the borrower
does not actually receive all of the monies that are loaned because they must keep on
deposit with the bank some of the money as the compensating balance. However, they
must pay interest on the full amount of the loan. The interest payable divided by the
usable funds equals the effective annual rate.
Explanation for Choice C:
This is the stated interest rate on the loan. In a loan with a compensating balance the
borrower does not actually receive all of the monies that are loaned because they must
 Hock P2 2020
Section B - Corporate Finance.
Answers
keep on deposit with the bank some of the money as the compensating balance.
However, they must pay interest on the full amount of the loan. Because of this the
effective interest rate on the loan is higher than the stated (or nominal) rate of the loan.
The interest payable divided by the usable funds equals the effective annual rate.
342. Question ID: CMA 696 1.30 (Topic: Short-term Bank Loans and Other S-T
Financing)
A company enters into an agreement with a firm that will factor the company's accounts
receivable. The factor agrees to buy the company's receivables, which average
$100,000 per month and have an average collection period of 30 days. The factor will
advance up to 80% of the face value of receivables at an annual rate of 10% and
charge a fee of 2% on all receivables purchased. The controller of the company
estimates that the company would save $18,000 in collection expenses over the year.
Fees and interest are not deducted in advance. Assuming a 360-day year, what is the
annual cost of financing?

 A. 17.5%correct
 B. 12.0%
 C. 14.0%
 D. 10.0%
Question was not answered
Correct Answer Explanation:
In the process of factoring the receivables, the company will save $18,000 per year in
collection expenses. However, there will also be some costs associated with this. Of the
amount sold, the company will lose 2% of the amount of receivables. This is $24,000
per year ($100,000 × 12 × 0.02), giving a net cost of $6,000 per year. Additionally, they
will need to pay 10% interest on the amount that is advanced to them connected to the
factoring. They will receive 80% of the monthly amount of receivables, or $80,000 and
because this will be done each month we can treat this as if there is always $80,000
outstanding during the year. The annual interest on this is $8,000 and adding this to the
$6,000 net cost gives a total cost of $14,000 to receive a loan of $80,000. Therefore the
cost is 17.5% ($14,000 ÷ $80,000).
Explanation for Choice B:
This answer does not count the 2% for each month, but only for one month. See the
correct answer for a complete explanation.
Explanation for Choice C:
This is the net annual cost divided by the gross amount of receivables sold. The net
annual cost should be divided by the net amount of funding available to the company
instead.
Explanation for Choice D:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This answer does not include the factor's fee. See the correct answer for a complete
explanation.
343. Question ID: CMA 696 1.14 (Topic: Short-term Bank Loans and Other S-T
Financing)
Which one of the following responses is not an advantage to a corporation that uses the
commercial paper market for short-term financing?

 A. The borrower avoids the expense of maintaining a compensating balance with a

commercial bank.
 B. This market provides more funds at lower rates than other methods provide.
 C. There are no restrictions as to the type of corporation that can enter into this
market.correct
 D. This market provides a broad distribution for borrowing.
Question was not answered
Correct Answer Explanation:
Because commercial paper is a source of unsecured financing, only the most
creditworthy companies can issue commercial paper. Thus, there are restrictions as to
the type of corporation that can enter the market.
Explanation for Choice A:
Commercial paper requires no compensating balance, so this is an advantage of
commercial paper.
Explanation for Choice B:
Commercial paper does provide a lower rate than many other methods of financing, so
this is an advantage of commercial paper.
Explanation for Choice D:
The commercial paper market does provide a broad distribution for borrowing, so this is
an advantage of commercial paper.
344. Question ID: CMA 694 1.29 (Topic: Short-term Bank Loans and Other S-T
Financing)
A firm that often factors its accounts receivable has an agreement with its finance
company that requires the firm to maintain a 6% reserve and charges 1% commission
on the amount of receivables. The net proceeds would be further reduced by an annual
interest charge of 10% on the monies advanced. Assuming a 360-day year, what
amount of cash (rounded to the nearest dollar) will the firm receive from the finance
company at the time a $100,000 account that is due in 90 days is turned over to the
finance company assuming the firm withdraws the full amount of cash available
immediately?
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. $93,000
 B. $90,000
 C. $83,700
 D. $90,675correct
Question was not answered
Correct Answer Explanation:
The amount that is going to be received is going to be calculated by starting with the
amount of the receivable itself, $100,000. This will be reduced by the reserve and the
commission, both of which are calculated from the $100,000 amount. In total, this is 7%
and reduces the amount to $93,000. This is the amount on which the interest will be
charged. The interest rate is 10% and this gives an annual interest of $9,300. However,
the time period before the receivable is due to be collected is only 3 months, so only 1/4
of the annual interest will be charged. This is $2,325. This is also withheld from the
amount received and brings the amount received down to $90,675. If all of the
receivables are actually collected when they become due, the company will receive an
additional $6,000 that was withheld as the reserve. In fact, any amount collected in
excess of $94,000 will be received by the company that sold the receivables.
Explanation for Choice A:
This answer does not take into account the interest that is charged on the amount to be
paid to the seller. See the correct answer for a complete explanation.
Explanation for Choice B:
This answer deducts an entire year of interest and ignores the reserve and commission.
See the correct answer for a complete explanation.
Explanation for Choice C:
This answer charges an entire year's interest on the amount that is to be paid (loaned)
to the seller of the receivables. Because the receivables are only 180 day receivables,
only one-quarter of the annual interest should be deducted. See the correct answer for
a complete explanation.
345. Question ID: ICMA 10.P2.185 (Topic: Short-term Bank Loans and Other S-T
Financing)
Frame Industries has arranged a revolving line of credit for the upcoming year with a
commercial bank. The arrangement is for $20 million, with interest payable monthly on
the amount utilized at the bank's prime rate and an annual commitment fee of one-half
of 1 percent, computed and payable monthly on the unused portion of the line. Frame
estimates that the prime rate for the upcoming year will be 8%, and expects the
following average amounts to be borrowed by quarter.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Amount
Quarter Borrowed
First $10,000,000
Second 20,000,000
Third 20,000,000
Fourth 5,000,000
How much will Frame owe to the bank next year in interest and fees?

 A. $1,118,750.
 B. $1,168,750.
 C. $1,200,000.
 D. $1,131,250.correct
Question was not answered
Correct Answer Explanation:
The average loan balance outstanding that Frame expects to use during the upcoming
year is ($10,000,000 + $20,000,000 + $20,000,000 + $5,000,000) ÷ 4 = $13,750,000.
The total interest due on the loan balance outstanding during the year is therefore
expected to be $13,750,000 × 0.08, or $1,100,000.
The commitment fee is due at an annual rate of one-half of 1 percent on the unused
portion. The total committed line amount is $20,000,000, and the planned average
balance outstanding is $13,750,000. Therefore, the average unused portion of the line
is expected to be $20,000,000 − $13,750,000, or $6,250,000. The total commitment fee
on the unused balance for the year is thus expected to be $6,250,000 × 0.005, or
$31,250.
The total amount owed to the bank next year in interest and fees is therefore
$1,100,000 + $31,250, or $1,131,250.
Note that since the same balance will not be outstanding on the line for each of the 4
quarters, the interest and commitment fees due will not be the same for each quarter
during the upcoming year. If quarterly amounts are needed for planning purposes, the
interest and commitment fee will need to be calculated separately for each quarter using
that quarter's planned outstanding balance and unused amount. However, quarterly
amounts are not required to answer this question.
Explanation for Choice A:
This answer omits the commitment fee for the first quarter.
Explanation for Choice B:
 Hock P2 2020
Section B - Corporate Finance.
Answers
This answer results from calculating a commitment fee of $18,750 for both the second
quarter and the third quarter. During the second and third quarters the line is completely
drawn down, so there is no unused portion of the line and no commitment fee is
charged.
Explanation for Choice C:
This answer results from calculating a commitment fee of $25,000 for each of the four
quarters. A commitment fee of $25,000 per quarter would be due only if the
$20,000,000 line were unused all year, because the commitment fee is due on the
unused portion of the line only.
346. Question ID: ICMA 10.P2.161 (Topic: Working Capital Policy )
Atlantic Distributors is expanding and wants to increase its level of inventory to support
an aggressive sales target. They would like to finance this expansion using debt.
Atlantic currently has loan covenants that require the current ratio to be at least 1.2. The
average cost of the current liabilities is 12% and the cost of the long-term debt is 8%.
Below is the current balance sheet for Atlantic.

Current assets $200,000 Current Liabilities $165,000

Fixed assets 100,000 Long-term debt 100,000
Equity 35,000
Total assets $300,000 Total debt & equity $300,000
Which one of the following alternatives will provide the resources to expand the
inventory while lowering the total cost of debt and satisfying the loan covenant?

 A. Collect $25,000 accounts receivable; use $10,000 to purchase inventory and use the
balance to reduce short-term debt.correct
 B. Borrow short-term funds of $25,000, and purchase inventory of $25,000.
 C. Increase both accounts payable and inventory by $25,000.
 D. Sell fixed assets with a book value of $20,000 for $25,000 and use the proceeds to
increase inventory.
Question was not answered
Correct Answer Explanation:
After collecting $25,000 in accounts receivable, using $10,000 of it to purchase
inventory and the balance to reduce short-term debt, the current ratio would become
1.23, which would be in compliance with the loan covenant.
Collection of $25,000 in accounts receivable would not change current assets, because
the collection would increase cash by the same amount that that accounts receivable
was reduced.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Use of $10,000 cash to purchase inventory would also not change current assets,
because cash would be reduced and inventory would be increased by the same
amount.
However, use of the remaining $15,000 in cash to reduce short-term debt would reduce
current assets and current liabilities both by $15,000. Therefore, current assets would
become $185,000 and current liabilities would become $150,000, resulting in a current
ratio of 1.23.
The question asks, "Which one of the following alternatives will provide the resources to
expand the inventory while lowering the total cost of debt and satisfying the loan
covenant?"
This will provide the resources to increase inventory by $10,000 while lowering short-
term debt by $15,000, which will mean lower interest cost. Furthermore, the current ratio
remains above 1.2, which satisfies the loan covenant.
Explanation for Choice B:
This will not provide the resources to expand the inventory while lowering the total cost
of debt and satisfying the loan covenant. Current assets would become $225,000 and
current liabilities would become $190,000. This would decrease the current ratio from
1.21 to 1.18, and the company would no longer be in compliance with its loan covenant.
It would also not lower the total cost of debt — in fact it would increase it — because
interest-incurring outstanding debt would increase.
Explanation for Choice C:
This will not provide the resources to expand the inventory while lowering the total cost
of debt and satisfying the loan covenant. Current assets would become $225,000 and
current liabilities would become $190,000. This would decrease the current ratio from
1.21 to 1.18, and the company would no longer be in compliance with its loan covenant.
It would also not lower the total cost of debt because interest-incurring outstanding debt
would be unchanged.
Explanation for Choice D:
This will not provide the resources to expand the inventory while lowering the total cost
of debt and satisfying the loan covenant. While it would increase inventory and increase
the current ratio from 1.21 to 1.36, it would not lower the cost of debt because interest-
incurring outstanding debt would be unchanged.
347. Question ID: CMA 692 1.25 (Topic: Working Capital Policy )
Net working capital is the difference between

 A. Total assets and total liabilities.

 B. Shareholders' investment and cash.
 C. Current assets and current liabilities.correct
 Hock P2 2020
Section B - Corporate Finance.
Answers
 D. Fixed assets and fixed liabilities.
Question was not answered
Correct Answer Explanation:
Net working capital, or simply working capital, is current assets minus current liabilities.
Explanation for Choice A:
The difference between total assets and total liabilities is stockholders' equity.
Explanation for Choice B:
This is not the definition of net working capital. Net working capital, or simply working
capital, is current assets minus current liabilities.
Explanation for Choice D:
This is not the definition of net working capital. Net working capital, or simply working
capital, is current assets minus current liabilities.
348. Question ID: CMA 697 1.10 (Topic: Working Capital Policy )
Which one of the following transactions does not change the current ratio and does not
change the total current assets?

 A. Short-term notes payable are retired with cash.

 B. A fully depreciated asset is sold for cash.
 C. A cash advance is made to a divisional office.correct
 D. A cash dividend is declared.
Question was not answered
Correct Answer Explanation:
A "division" of a company is a part of the company. If the division maintains its own
complete set of accounting records, the home office will maintain a reciprocal ledger
account such as "Investment in Branch." When financial statements are issued, they are
combined statements. In the preparation of the combined financial statements,
reciprocal ledger accounts are eliminated because they have no significance when the
home office and the branch financial statements are prepared since they are one legal
entity. Thus, all interoffice transactions are eliminated. Since an advance from the home
office to one of its divisional offices is strictly an internal transaction within the company,
it would not cause any change in any of the ratios or in the total current assets of the
company.
Explanation for Choice A:
Retiring short-term notes payable with cash will decrease both current assets and
current liabilities by the same absolute amount. If current assets are greater than
current liabilities (as they should be but aren't always), the same absolute amount of
 Hock P2 2020
Section B - Corporate Finance.
Answers
decrease in both will cause the current ratio to increase. If current liabilities are greater
than current assets, the same absolute amount of decrease in both will cause the
current ratio to decrease. Therefore, both current assets and the current ratio will
change as a result of this transaction.
Explanation for Choice B:
The sale of the asset for cash will increase current assets while decreasing long-term
assets and will have no effect on current liabilities. Thus both the current ratio and the
balance of current assets will change.
Explanation for Choice D:
A cash dividend declared will not change current assets but it will cause current
liabilities to increase. Therefore, it will cause the current ratio to change.
349. Question ID: CMA 1292 1.22 (Topic: Working Capital Policy )
Shaw Corporation is considering a plant expansion that will increase its sales and net
income. The following data represent management's estimate of the impact the
proposal will have on the company:

Current Proposal
Cash $100,000 $120,000
Accounts payable 350,000 430,000
Accounts receivable 400,000 500,000
Inventory 380,000 460,000
Marketable securities 200,000 200,000
Mortgage payable (current) 175,000 325,000
Fixed assets 2,500,000 3,500,000
Net income 500,000 650,000
The effect of the plant expansion on Shaw's working capital will be a(n)

 A. Decrease of $30,000.correct
 B. Increase of $120,000.
 C. Decrease of $150,000.
 D. Increase of $30,000.
Question was not answered
Correct Answer Explanation:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Currently,, the company has working capital of $555,000: ($100,000 + 400,000 +
380,000 + 200,000) − ($350,000 + $175,000).
Under the proposed plan working capital would be $525,000: ($120,000 + $500,000 +
$460,000 + $200,000) − ($430,000 + $325,000).
This is a decrease of $30,000 from $555,000 to $525,000.
Explanation for Choice B:
This answer results from not including the current portion of the mortgage payable as a
current liability. Current maturities of long-term debt are current liabilities, so the
increase in the current portion of the mortgage payable decreases net working capital.
Explanation for Choice C:
This answer could result from considering only the current portion of the mortgage
payable as equivalent to working capital. The current portion of the mortgage payable is
a current liability and so it is a component of working capital. However, working capital
consists of all current assets minus all current liabilities, so there are more components
to be included in calculating the change in working capital.
If you have calculated this incorrect answer in another way, please let us know how you
did it so we can add that to this answer explanation. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears at the top of the question. Thank you
in advance for helping us to make your HOCK study materials better.
Explanation for Choice D:
This answer could result from omitting cash and accounts payable from the calculation
of the difference in working capital. Working capital consists of all current assets minus
all current liabilities. Cash is a current asset and accounts payable is a current liability,
so they should both be included.
If you have calculated this incorrect answer in another way, please let us know how you
did it so we can add that to this answer explanation. Please send us an email at
support@hockinternational.com. Include the full Question ID number and the actual
incorrect answer choice -- not its letter, because that can change with every study
session created. The Question ID number appears in the upper right corner of the
ExamSuccess screen. Thank you in advance for helping us to make your HOCK study
materials better.
350. Question ID: CMA 1294 1.15 (Topic: Working Capital Policy )
Which one of the following would increase the working capital of a firm?

 A. Cash payment of payroll taxes payable.

 B. Cash collection of accounts receivable.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 C. Purchase of a new plant financed by a 20-year mortgage.
 D. Refinancing a short-term note payable with a two-year note payable.correct
Question was not answered
Correct Answer Explanation:
Working capital is calculated as current assets minus current liabilities. The refinancing
of a short-term note with a 2-year note will reduce current liabilities while increasing
long-term liabilities without a corresponding reduction in current assets. This will cause
working capital to increase.
Explanation for Choice A:
Working capital is calculated as the current assets minus the current liabilities. The cash
payment of taxes payable will decrease both current assets and current liabilities by the
same amount. Therefore, working capital will be unchanged as a result of this
transaction.
Explanation for Choice B:
Working capital is calculated as the current assets minus the current liabilities. The
collection of accounts receivable will increase cash and decrease accounts receivable
by the same amount, and current assets will not change. Therefore, working capital will
be unchanged as a result of this transaction.
Explanation for Choice C:
Working capital is calculated as the current assets minus the current liabilities. The new
plant is a noncurrent asset and the 20-year mortgage is a noncurrent liability. The
current portion of the mortgage principal (the portion of the principal due within 12
months or the operating cycle, whichever is longer) would be a current liability, however.
Therefore, working capital will be reduced as a result of this transaction.
351. Question ID: CMA 691 1.4 (Topic: Working Capital Policy )
Which group of measures would be useful in evaluating the effectiveness of working
capital management?

 A. Acid-test ratio, inventory turnover ratio, and average collection period.correct

 B. Inventory turnover ratio, times interest earned, and debt-to-equity ratio.
 C. Profit margin, acid-test ratio, and return on assets.
 D. Acid-test ratio, current ratio, and return on equity.
Question was not answered
Correct Answer Explanation:
All of these listed measures are useful in evaluating the effectiveness of working capital
management. The acid test, or quick, ratio measures the firm's ability to pay its short-
term debts using its most liquid assets. The inventory turnover indicates how many
 Hock P2 2020
Section B - Corporate Finance.
Answers
times during the year the company sells its average level of inventory and so is an
indicator of how well the inventory is being managed. The average collection period is a
measure of how efficiently the company is collecting its accounts receivable.
Explanation for Choice B:
Times interest earned and the debt-to-equity ratios are not related to working capital
management.
Explanation for Choice C:
Profit margin and return on assets measure profitability, not working capital
management.
Explanation for Choice D:
The return on equity ratio is not a measure used in evaluating the effectiveness of
working capital management.
352. Question ID: ICMA 19.P2.080 (Topic: Working Capital Policy )
As a company becomes more conservative about its working capital management
policy, it would most likely tend to have a(n)

 A. increase in the ratio of current assets to noncurrent assets.correct

 B. decrease in the quick ratio.
 C. increase in the ratio of current liabilities to noncurrent liabilities.
 D. decrease in the operating cycle.
Question was not answered
Correct Answer Explanation:
A more conservative working capital policy means that the company wants to reduce
the risk of not being able to pay its liabilities as they come due. It can do this by holding
more current assets than noncurrent assets.
Explanation for Choice B:
A more conservative working capital policy means that the company wants to reduce
the risk of not being able to pay its liabilities as they come due. Decreasing the quick
ratio would increase the chance of not being able to pay a liability as it comes doe
because the company holding a lower proportion of current assets compared to current
liabilities.
Explanation for Choice C:
A more conservative working capital policy means that the company wants to reduce
the risk of not being able to pay its liabilities as they come due. Having proportionately
more current liabilities does not do this.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice D:
A more conservative working capital policy means that the company wants to reduce
the risk of not being able to pay its liabilities as they come due. Decreasing the
operating cycle does not do this.
353. Question ID: CMA 1294 1.30 (Topic: Working Capital Policy )
If a firm increases its cash balance by issuing additional shares of common stock,
working capital

 A. Increases and the current ratio decreases.

 B. Increases and the current ratio remains unchanged.
 C. Remains unchanged and the current ratio remains unchanged.
 D. Increases and the current ratio increases.correct
Question was not answered
Correct Answer Explanation:
Working capital is calculated as current assets minus current liabilities. The current ratio
is calculated as current assets divided by current liabilities. If the company issues
shares for cash, current assets will increase and current liabilities will be unchanged.
This will cause working capital to increase and the current ratio to increase.
Explanation for Choice A:
Working capital is current assets minus current liabilities. The current ratio is current
assets divided by current liabilities. Because both working capital and the current ratio
use the same amounts, it is not possible for working capital to increase while the current
ratio decreases. If one increases, the other must also increase; and if one decreases,
the other must also decrease.
Explanation for Choice B:
Working capital is current assets minus current liabilities. The current ratio is current
assets divided by current liabilities. Because both working capital and the current ratio
use the same amounts, it is not possible for one of them to change while the other
remains unchanged.
Explanation for Choice C:
Working capital and the current ratio will not remain unchanged. Cash will be affected,
and cash is a current asset that affects both working capital and the current ratio.
354. Question ID: ICMA 10.P2.172 (Topic: Working Capital Policy )
Of the following, the working capital financing policy that would subject a firm to
the greatest level of risk is the one where the firm finances

 A. fluctuating current assets with long-term debt.

 Hock P2 2020
Section B - Corporate Finance.
Answers
 B. permanent current assets with short-term debt.correct
 C. fluctuating current assets with short-term debt.
 D. permanent current assets with long-term debt.
Question was not answered
Correct Answer Explanation:
This question is about the maturity matching approach to financing. The maturity
matching approach to financing current assets (also called the hedging or the self-
liquidating approach) matches assets to be financed with financing having the same
maturity.
Even though the assets being financed with short-term debt are current assets, if they
are permanent, they will not be liquidated the way other current assets would be.
Examples of permanent current assets are accounts receivable and inventory in a non-
seasonal business or in a growing business. Inventory is sold, but it is immediately
replaced with new inventory, so the level of investment in inventory remains the same.
Accounts receivable get collected, but they are immediately replaced by accounts
receivable for other sales, so the level of accounts receivable also remains the same.
And in a firm that is growing, accounts receivable and inventory don't just remain the
same — they increase. And they continue increasing until the firm's growth stops. In
either a non-seasonal business or in a growing business, the level of the accounts
receivable and inventory required to support sales will be permanent and they should be
financed with long-term debt. (If the business is seasonal, at least a portion of their
accounts receivable and inventory will be liquidated after the selling season, so only a
portion of their accounts receivable and inventory will be permanent.)
If a company finances permanent, long-term assets with short-term debt, it may be able
to lower its interest costs, if short-term interest rates are lower than long-term fixed
interest rates (which is usually the case). However, it runs two risks: (1) of not being
able to renew the short-term financing when it matures and being required to pay it off
when funds are not available because the current assets have not been liquidated,
potentially putting the firm into bankruptcy; and (2) of being forced to renew the short-
term debt at a higher interest rate in a period of rising interest rates. If short-term
interest rates increase enough, the firm may find itself paying a higher rate of interest
than it would have paid if it had originally financed the permanent assets using long-
term, fixed rate financing.
Because of the risks involved, using short-term financing for long-term, permanent
assets is considered an aggressive, risky approach to financing. The greater the
proportion of permanent assets financed with short-term debt, the more aggressive the
financing is and the greater the level of risk the firm faces.
Explanation for Choice A:
This question is about the maturity matching approach to financing. The maturity
matching approach to financing current assets (also called the hedging or the self-
 Hock P2 2020
Section B - Corporate Finance.
Answers
liquidating approach) matches assets to be financed with financing having the same
maturity.
It is not appropriate to finance fluctuating current assets with long-term debt because
the firm could find at times that not all of its long-term borrowings are required to finance
the level of current assets. The result will be that the firm will be paying interest on loan
balances that it does not need. If the firm chooses to pay down the long-term loan
principal during a period when it does not need all of the borrowings, the next time the
current assets increase and the firm needs the financing for them, the financing may not
be there.
However, this question asks for the working capital financing policy that would subject a
firm to the greatest level of risk. This policy is not the riskiest of the answer choices and
thus it is not the best answer choice.
Explanation for Choice C:
This question is about the maturity matching approach to financing. The maturity
matching approach to financing current assets (also called the hedging or the self-
liquidating approach) matches assets to be financed with financing having the same
maturity.
It is appropriate to finance fluctuating current assets with short-term debt. A financing
policy like this enables a firm to borrow only what it needs for only as long as it needs it.
This minimizes its interest costs because it does not have borrowed funds on hand that
it is not using.
Explanation for Choice D:
It is appropriate to finance permanent current assets with long-term debt.
This question is about the maturity matching approach to financing. The maturity
matching approach to financing current assets (also called the hedging or the self-
liquidating approach) matches assets to be financed with financing having the same
maturity.
Examples of permanent current assets are accounts receivable and inventory in a non-
seasonal business or in a growing business. Inventory is sold, but it is immediately
replaced with new inventory, so the level of investment in inventory remains the same.
Accounts receivable get collected, but they are immediately replaced by accounts
receivable for other sales, so the level of accounts receivable also remains the same.
And in a firm that is growing, accounts receivable and inventory don't just remain the
same — they increase. And they continue increasing until the firm's growth stops. In
either a non-seasonal business or in a growing business, the level of the accounts
receivable and inventory required to support sales will be permanent. (If the business is
seasonal, at least a portion of their accounts receivable and inventory will be liquidated
after the selling season, so only a portion of their accounts receivable and inventory will
be permanent.)
 Hock P2 2020
Section B - Corporate Finance.
Answers
355. Question ID: ICMA 19.P2.079 (Topic: Working Capital Policy )
Which one of the following combined transactions would cause net working capital to
decrease?

 A. A $1 million decrease in cash, and a $1 million increase in fixed assets.correct

 B. A $1 million decrease in cash, and a $1 million decrease in accounts payable.
 C. A $1 million decrease in cash, and a $1 million increase in inventory.
 D. A $1 million increase in cash, and a $1 million increase in long-term debt.
Question was not answered
Correct Answer Explanation:
A decrease in cash would cause working capital to decrease. Fixed assets are not part
of working capital so the increase in fixed assets does not impact working capital.
Explanation for Choice B:
These transactions would cause no change in working capital.
Explanation for Choice C:
These transactions would cause no change in working capital.
Explanation for Choice D:
These transactions would cause working capital to increase.
356. Question ID: CMA 697 1.7 (Topic: Working Capital Policy )
Which one of the following transactions would increase the current ratio and decrease
net profit?

 A. Uncollectible accounts receivable are written off against the allowance account.
 B. A stock dividend is declared.
 C. Vacant land is sold for cash for less than the net book value.correct
 D. A federal income tax payment due from the previous year is paid.
Question was not answered
Correct Answer Explanation:
Land being sold for less than the book value will create a loss, and the fact that the land
was sold for cash causes an increase in the current assets of the company, which will
increase the current ratio.
Explanation for Choice A:
The writing off of receivables against the allowance account does not affect net income
of the current period or the current ratio. See the correct answer for a complete
explanation.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Explanation for Choice B:
The declaration of a stock dividend would not affect net income for the current period,
nor would it affect the current ratio. See the correct answer for a complete explanation.
Explanation for Choice D:
The payment of last year's taxes does not impact the net profit in the current period.
See the correct answer for a complete explanation.
357. Question ID: CMA 1292 1.23 (Topic: Working Capital Policy )
A firm's current ratio is 1.75 to 1. According to a working capital restriction in the firm's
bond indenture, the firm will technically default if the current ratio falls below 1.5 to 1. If
current liabilities are $250 million, the maximum new commercial paper that can be
issued to finance inventory expansion an equivalent amount without a technical default
is

 A. $125.00 million.correct
 B. $375.00 million.
 C. $62.50 million.
 D. $437.50 million.
Question was not answered
Correct Answer Explanation:
Though this question may appear difficult it is actually just an algebraic formula. The
current ratio must not be less than 1.5 so this means that current assets must be 1.5
times current liabilities. If current liabilities are currently $250 million and the current
ratio is currently 1.75, that means current assets are $437.5 million (250 × 1.75). The
issuance of commercial paper will increase both current assets and current liabilities by
the amount of the commercial paper to be issued. So the question can now be
expressed as a formula, where X is the amount of the commercial paper to be issued:

(437.5 + X)
= 1.5
(250 + X)
We can now solve for X. The steps are:
1. Multiply both sides of the equation by (250 + X) to get the (250 + X) out of the
denominator:
(437.5 + X) = 1.5(250 + X)
437.5 + X = 375 + 1.5X
2. Subtract 1X from both sides of the equation:
437.5 = 375 + 0.5X
 Hock P2 2020
Section B - Corporate Finance.
Answers
3. Subtract 375 from both sides of the equation:
62.5 = 0.5X
4. Divide both sides of the equation by 0.5:
125 = X
... which is the amount of commercial paper the company can issue without its current
ratio falling below 1.5.
Explanation for Choice B:
This is the amount of current assets that will be needed in order to prevent a violation of
the restriction. See the correct answer for a complete explanation.
Explanation for Choice C:
If the company were to issue only $62.5 million of commercial paper, they would not be
in default of the restriction, but their current ratio would still be above 1.5. This is not the
maximum commercial paper that may be issued. See the correct answer for a complete
explanation.
Explanation for Choice D:
If the company were to issue this much commercial paper, their current ratio would be
lower than 1.5 and they would be in default of their restriction.
358. Question ID: CMA 697 1.16 (Topic: Working Capital Policy )
MFC Corporation has 100,000 shares of stock outstanding. Below is part of MFC's
Statement of Financial Position for the last fiscal year.

MFC Corporation
Statement of Financial Position - Selected Items
December 31
Cash $455,000
Accounts receivable 900,000
Inventory 650,000
Prepaid assets 45,000
Accrued liabilities 285,000
Accounts payable 550,000
Current portion, long-term notes payable 65,000
 Hock P2 2020
Section B - Corporate Finance.
Answers
What is the maximum amount MFC can pay in cash dividends per share and maintain a
minimum current ratio of 2 to 1? Assume that all accounts other than cash remain
unchanged.

 A. $2.50correct
 B. $2.05
 C. $3.80
 D. $3.35
Question was not answered
Correct Answer Explanation:
Current assets currently total $2,050,000 (cash, accounts receivable, inventory, and
prepaid assets). Current liabilities total $900,000 (accrued liabilities, accounts payable,
and current portion long-term debt). At present, the current ratio is 2.28 ($2,050,000 of
current assets divided by $900,000 of current liabilities). We need to know how much
MFC can distribute as cash and still maintain a current ratio of 2.00. The formula we
need to use is ($2,050,000 − X) / $900,000 = 2. Solving for X we get $250,000. This is
the amount of the dividend that they may pay this year. Since there are 100,000 shares
outstanding, the amount that may be paid per share is $2.50.
Explanation for Choice B:
This answer does not include prepaid assets as a current asset. See the correct answer
for a complete explanation.
Explanation for Choice C:
This answer does not include the current portion of the long-term debt in the current
liabilities. See the correct answer for a complete explanation.
Explanation for Choice D:
This answer does not include prepaid assets as a current asset or the current portion of
the long-term debt in the current liabilities. See the correct answer for a complete
explanation.
359. Question ID: CMA 696 1.16 (Topic: Working Capital Policy )
Determining the appropriate level of working capital for a firm requires

 A. Maintaining short-term debt at the lowest possible level because it is generally more
expensive than long-term debt.
 B. Offsetting the benefit of current assets and current liabilities against the probability of
technical insolvency.correct
 C. Changing the capital structure and dividend policy of the firm.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 D. Maintaining a high proportion of liquid assets to total assets in order to maximize the
return on total investments.
Question was not answered
Correct Answer Explanation:
Working capital management requires balancing the risk of insolvency with the benefits
of longer-term, higher-return investments.
Explanation for Choice A:
Short-term debt is generally less expensive than long-term debt and working capital
management is more than just debt management.
Explanation for Choice C:
The capital structure and dividend policy of a firm are not part of the working capital
management process.
Explanation for Choice D:
Maintaining high levels of liquid assets would not maximize the return on total assets
because short-term assets have a lower return than longer-term assets.
360. Question ID: CMA 688 1.17 (Topic: Working Capital Policy )
In general, as a company increases its amount of short-term financing relative to long-
term financing, the

 A. leverage of the firm increases.

 B. likelihood of having idle liquid assets increases.
 C. current ratio increases.
 D. greater will be the risk that it will be unable to meet principal and interest
payments.correct
Question was not answered
Correct Answer Explanation:
If the borrowed funds are short-term, the company will need to obtain new financing
more often as the old source of financing matures. This will require more frequent
refinancing of the principal which increases the chance that funds to refinance the debt
will not be available or will be available but at a much higher interest rate.
Explanation for Choice A:
Leverage measures the use of borrowed money. It does not matter if those borrowings
are short-term or long-term.
Explanation for Choice B:
 Hock P2 2020
Section B - Corporate Finance.
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The period of time for which the borrowed funds are outstanding does not impact the
amount of idle liquid assets that the company has.
Explanation for Choice C:
As the current liabilities of the company increase, the current ratio will decrease.
361. Question ID: CMA 696 1.29 (Topic: Working Capital Policy )
All of the following statements in regard to working capital are correct except

 A. Current liabilities are an important source of financing for many small firms.
 B. The hedging approach to financing involves matching maturities of debt with specific
financing needs.
 C. Profitability varies inversely with liquidity.
 D. Financing permanent inventory buildup with long-term debt is an example of an
aggressive working capital policy.correct
Question was not answered
Correct Answer Explanation:
An aggressive working capital management policy uses short-term sources of finance
rather than long-term sources. Therefore, this is an example of a conservative working
capital policy.
Explanation for Choice A:
This is a true statement. The payment terms available in accounts payable are an
important source of financing for firms, particularly, smaller firms.
Explanation for Choice B:
The hedging approach to financing current assets does involve matching specific
financing needs with maturities of specific sources of financing.
Explanation for Choice C:
This is a true statement because the more liquid an investment is, the lower its rate of
return will be.
362. Question ID: CMA 1293 1.19 (Topic: Working Capital Policy )
Starrs Company has current assets of $300,000 and current liabilities of $200,000.
Starrs could increase its working capital by the

 A. Purchase of $50,000 of temporary investments for cash.

 B. Prepayment of $50,000 of next year's rent.
 C. Refinancing of $50,000 of short-term debt with long-term debt.correct
 D. Collection of $50,000 of accounts receivable.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Question was not answered
Correct Answer Explanation:
A transaction that involves the elimination of a current liability by replacing it with a long-
term liability will decrease current liabilities and thus increase the level of working
capital.
Explanation for Choice A:
The purchase of temporary investments for cash simply increases one current asset
(investments) and decreases another current asset (cash) by the same amount. Total
current assets will not change, and the level of working capital will remain the same.
Explanation for Choice B:
The prepayment of expenses simply increases one current asset (prepaids) and
decreases another current asset (cash) by the same amount. Total current assets will
not change, and the level of working capital will remain the same.
Explanation for Choice D:
The collection of accounts receivable simply increases one current asset (cash) and
decreases another current asset (receivables) by the same amount. Total current
assets will not change, and the level of working capital will remain the same.
363. Question ID: CMA 1290 1.19 (Topic: Working Capital Policy )
During the year, Mason Company's current assets increased by $120, current liabilities
decreased by $50, and net working capital

 A. Did not change.

 B. Decreased by $170.
 C. Increased by $70.
 D. Increased by $170.correct
Question was not answered
Correct Answer Explanation:
Net working capital is total current assets minus total current liabilities. Anything that
increases current assets or decreases current liabilities will increase net working capital,
and vice versa. Therefore, both the increase to Mason Company's current assets and
the decrease to its current liabilities would cause increases in net working capital.
Since both the increase in current assets and the decrease in current liabilities will
cause increases in net working capital, the easiest way to solve this is to simply add the
two change amounts together to calculate the amount of the total increase.
Another way to solve this is to create a simple example. Let us assume that now the
company has current assets of $150 and current liabilities of $75. This gives it a working
 Hock P2 2020
Section B - Corporate Finance.
Answers
capital level of $75. If the current assets increase by $120 they will be $270. If current
liabilities decrease by $50, they will be $25; this gives the company a working capital of
$245. This is a $170 increase.
Explanation for Choice A:
Net working capital is total current assets minus total current liabilities. Anything that
increases current assets or decreases current liabilities will increase net working capital,
and vice versa. Therefore, both the increase to Mason Company's current assets and
the decrease to its current liabilities would cause an increase in net working capital.
Explanation for Choice B:
Net working capital is total current assets minus total current liabilities. Anything that
increases current assets or decreases current liabilities will increase net working capital,
and vice versa. Therefore, both the increase to Mason Company's current assets and
the decrease to its current liabilities would cause an increase in net working capital, not
a decrease.
Explanation for Choice C:
Net working capital is total current assets minus total current liabilities. Anything that
increases current assets or decreases current liabilities will increase net working capital,
and vice versa. Therefore, both the increase to Mason Company's current assets and
the decrease to its current liabilities would cause increases in net working capital.
However, since both caused an increase in net working capital, the amount of the total
increase is the total of the two change amounts, not their net amount.
364. Question ID: CMA 1286 1.29 (Topic: Working Capital Policy )
Finan Corporation's management is considering a plant expansion that will increase its
sales and have commensurate impact on its net working capital position. The following
information presents management's estimate of the impact the proposal will have on
Finan.

Current Proposal
Cash $100,000 $110,000
Accounts payable 400,000 470,000
Accounts receivable 560,000 690,000
Inventory 350,000 380,000
Marketable securities 200,000 200,000
Fixed assets 2,500,000 3,500,000
Net income 500,000 650,000
The impact of the plant expansion on Finan's working capital would be
 Hock P2 2020
Section B - Corporate Finance.
Answers
 A. A decrease of $100,000.
 B. An increase of $100,000.correct
 C. A decrease of $950,000.
 D. An increase of $950,000.
Question was not answered
Correct Answer Explanation:
Working capital is calculated as current assets (cash, receivables, inventory and
marketable securities in this question) minus the current liabilities (accounts payable in
this question). Currently, the working capital is $810,000 ($100,000 + $560,000 +
$350,000 + $200,000 − $400,000). Under the new proposal it will be $910,000 (110,000
+ $690,000 + $380,000 + $200,000 − 470,000). This is an increase of $100,000 in the
working capital of the company.
Explanation for Choice A:
This is the amount of the change in working capital, but the level of working capital will
increase, not decrease, if the proposal is implemented.
Explanation for Choice C:
This answer results from including in working capital the increase in fixed assets and
deducting the increase in net income that will result from the plant expansion, and then
calculating the difference as a decrease instead of an increase. Neither fixed assets nor
net income are components of working capital.
Explanation for Choice D:
This answer results from including in working capital the increase in fixed assets and
deducting the increase in net income that will result from the plant expansion. Neither of
those items are components of working capital.
365. Question ID: CMA 1291 1.13 (Topic: Working Capital Policy )
When a firm finances each asset with a financial instrument of the same approximate
maturity as the life of the asset, it is applying

 A. Return maximization.
 B. A hedging approach.correct
 C. Working capital management.
 D. Financial leverage.
Question was not answered
Correct Answer Explanation:
Maturity matching, or matching the maturity date of an asset with the maturity date of
the debt instrument used to finance that asset, is a hedging approach. The basic
 Hock P2 2020
Section B - Corporate Finance.
Answers
concept is that the company has the entire life of the asset to recover the amount
invested before having to pay the lender.
Explanation for Choice A:
Return maximization is not a primary goal of working capital management.
Explanation for Choice C:
Working capital management is short-term asset and liability management. It may or
may not include matching of each asset with a liability of the same approximate
maturity.
Explanation for Choice D:
Financial leverage is the use of long-term debt to increase earnings. Financial leverage
is not a part of working capital management.
366. Question ID: CMA 1296 1.8 (Topic: Working Capital Policy )
As a company becomes more conservative in its working capital policy, it would tend to
have a(n)

 A. Increase in the ratio of current assets to units of output.correct

 B. Increase in the ratio of current liabilities to noncurrent liabilities.
 C. Decrease in its acid-test ratio.
 D. Increase in funds invested in common stock and a decrease in funds invested in
marketable securities.
Question was not answered
Correct Answer Explanation:
If the company becomes more conservative in their working capital policy, they will hold
more current assets than before. This would cause the ratio of current assets to units of
output to increase.
Explanation for Choice B:
A more conservative working capital policy would use more long-term financing than
short-term financing. Therefore, this ratio would decrease with a conservative working
capital policy.
Explanation for Choice C:
If the company becomes more conservative in their working capital policy, they will hold
more current assets than before. This would cause the acid-test ratio to increase.
Explanation for Choice D:
A company with a conservative working capital policy would want its short-term
investments to be more liquid so that there is less risk related to the conversion of those
 Hock P2 2020
Section B - Corporate Finance.
Answers
investments into cash. This would cause them to make more investments in marketable
securities and less in common stock.
367. Question ID: CIA 1192 IV.52 (Topic: Working Capital Policy )
The following are the January 1 and June 30 balance sheets of a company, in millions:

January 1 June 30
Cash $ 3 $ 4
Accounts receivable 5 4
Inventories 8 10
Fixed assets 10 11
Total assets $26 $29

Accounts payable 2 3
Notes payable 4 3
Accrued wages 1 2
Long-term debt 9 11
Stockholders' equity 10 10
Total liabilities and stockholders' equity $26 $29
From January 1 to June 30, the net working capital:

 A. Decreased by $1 million.
 B. Increased by $2 million.
 C. Stayed the same.
 D. Increased by $1 million.correct
Question was not answered
Correct Answer Explanation:
Net working capital is calculated as current assets minus current liabilities. At January 1,
current assets were $16 million and current liabilities were $7 million, giving a net
working capital of $9 million. At June 30, current assets were $18 million and current
liabilities were $8 million, giving a net working capital of $10 million. Thus, during the
period, net working capital increased by $1 million.
Explanation for Choice A:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Net working capital is current assets minus current liabilities. This answer does not
include inventory as a current asset in the net working capital calculation. See the
correct answer for a complete explanation.
Explanation for Choice B:
Net working capital is current assets minus current liabilities. This answer does not
include accrued wages as a current liability in the net working capital calculation. See
the correct answer for a complete explanation.
Explanation for Choice C:
Net working capital is current assets minus current liabilities. Total assets
minus total liabilities, which is equal to stockholders' equity, stayed the same. But net
working capital did not stay the same.
368. Question ID: CMA 694 1.30 (Topic: Working Capital Policy )
A firm's current ratio is 2 to 1. Its bond indenture states that its current ratio cannot fall
below 1.5 to 1. If current liabilities are $200,000, the maximum amount of new short-
term debt the firm can assume in order to finance inventory without defaulting is:

 A. $66,667
 B. $150,000
 C. $266,667
 D. $200,000correct
Question was not answered
Correct Answer Explanation:
The current ratio is calculated as the current assets divided by the current liabilities. If
the current liabilities are $200,000 and the ratio is 2 to 1, that means that current assets
are currently $400,000. New short-term debt will increase both the current assets and
the current liabilities by the same amount. Therefore, in order to determine the
maximum amount of debt that can be issued while maintaining a current ratio of at least
1.5 to 1, we need to set up the following formula, letting X represent the amount of
increase in both current assets and current liabilities:

(400 + X)
= 1.5
(200 + X)
We can now solve for X. The steps are:
1. Multiply both sides of the equation by (200 + X) to get the (200 + X) out of the
denominator, then simplify:
(400 + X) = 1.5(200 + X)
400 + X = 300 + 1.5X
 Hock P2 2020
Section B - Corporate Finance.
Answers
2. Subtract 1X from both sides of the equation:
400 = 300 + 0.5X
3. Subtract 300 from both sides of the equation:
100 = 0.5X
4. Divide both sides of the equation by 0.5:
200 = X
If the company issues $200,000 of new short-term debt, they will have current assets of
$600,000 and current liabilities of $400,000. This will give them a current ratio of 1.5 to
1. Any amount of debt greater than $200,000 will cause the current ratio to decrease
below 1.5 to 1, and any amount less than $200,000 is not the maximum amount that
they can borrow and still maintain a current ratio of 1.5 to 1.
Explanation for Choice A:
If the current liabilities are $200,000 and the ratio is 2 to 1, that means that current
assets are currently $400,000. New short-term debt will increase both the current assets
and the current liabilities by the same amount. New short-term debt in the amount of
$66,667 would increase current assets to $466,667 and would increase current
liabilities to $266,667. The current ratio would become 1.75, not 1.5.
Hint: Since both current assets and current liabilities will increase by the same amount,
the formula needed to solve this is

(400 + X)
= 1.5
(200 + X)
where X is the amount of the new short-term debt.
Explanation for Choice B:
If the current liabilities are $200,000 and the ratio is 2 to 1, that means that current
assets are currently $400,000. New short-term debt will increase both the current assets
and the current liabilities by the same amount. New short-term debt in the amount of
$150,000 would increase current assets to $550,000 and would increase current
liabilities to $350,000. The current ratio would become 1.57, not 1.5.
Hint: Since both current assets and current liabilities will increase by the same amount,
the formula needed to solve this is

(400 + X)
= 1.5
(200 + X)
where X is the amount of the new short-term debt.
Explanation for Choice C:
 Hock P2 2020
Section B - Corporate Finance.
Answers
If the current liabilities are $200,000 and the ratio is 2 to 1, that means that current
assets are currently $400,000. New short-term debt will increase both the current assets
and the current liabilities by the same amount. New short-term debt in the amount of
$266,667 would increase current assets to $666,667 and would increase current
liabilities to $466,667. The current ratio would become 1.43, not 1.5, and the company
would not be in compliance with the covenant in its bond indenture.
Hint: Since both current assets and current liabilities will increase by the same amount,
the formula needed to solve this is

(400 + X)
= 1.5
(200 + X)
where X is the amount of the new short-term debt.
369. Question ID: CMA 1290 1.23 (Topic: Working Capital Policy )
As a company becomes more conservative with respect to working capital policy, it
would tend to have a(n)

 A. Decrease in the operating cycle.

 B. Increase in the ratio of current liabilities to noncurrent liabilities.
 C. Increase in the ratio of current assets to noncurrent assets.correct
 D. Decrease in the quick ratio.
Question was not answered
Correct Answer Explanation:
A conservative working capital policy is one in which the company holds a lot of current
assets in order to be certain that they will not become technically insolvent as their
current liabilities come due. Therefore, under a conservative policy, the company will
increase the ratio of current assets to current liabilities.
Explanation for Choice A:
While decreasing the operating cycle will have some benefits, it also enables the
company to reduce its working capital since current assets will be converted to cash
more quickly. Therefore, decreasing the operating cycle is not something that a
company that wants to have a conservative working capital policy will automatically due.
Explanation for Choice B:
A conservative working capital policy is one in which the company holds a lot of current
assets in order to be certain that they will not become technically insolvent as their
current liabilities come due. Therefore, under a conservative policy, the company will
decrease the amount current liabilities and try to make their liabilities long-term liabilities
whenever possible.
Explanation for Choice D:
 Hock P2 2020
Section B - Corporate Finance.
Answers
A decrease in either the quick ratio or the current ratio indicates a more aggressive
working capital policy.
370. Question ID: ICMA 1603.P2.027 (Topic: Corporate Restructuring)
Clear Displays Inc. manufactures display screens for mobile devices and is looking to
expand their business through acquisition. Clear Displays has a weighted average cost
of capital of 10%. They are evaluating the opportunity to acquire one of their
competitors, Bright Screens Inc. Cash flows for Bright Screens are forecasted to be
$110,000 in each of the next four years, and net income for Bright Screens is forecasted
to be $90,000 in each of the next four years. The projected terminal value for Bright
Screens at the end of that four-year period is $1,250,000. Utilizing the discounted cash
flow method, the valuation for Bright Screens is expected to be

 A. $1,202,450.correct
 B. $1,535,300.
 C. $1,139,050.
 D. $1,598,700.
Question was not answered
Correct Answer Explanation:
The valuation for Bright Screens consists of two pieces: the present value of the near-
term cash flows (for the next four years) and the present value of the terminal, or
horizon, value of the company at the end of that four-year period.
The present value of the near-term cash flows is the forecasted annual cash flow of
$110,000 multiplied by the present value of annuity factor for 10%, the company's cost
of capital, for four years, which is 3.17.
$110,000 × 3.17 = $348,700.
The present value of the terminal, or horizon, value of the company at the end of the
four-year period is the terminal value of $1,250,000 multiplied by the present value of $1
factor for 10% for four years, which is 0.683.
$1,250,000 × 0.683 = $853,750.
The valuation for Bright Screens is $348,700 + $853,750, which equals $1,202,450.
Explanation for Choice B:
The valuation for Bright Screens consists of two pieces: the present value of the near-
term cash flows (for the next four years) and the present value of the terminal, or
horizon, value of the company at the end of that four-year period.
This answer results from two errors: (1) using the present value of the near-term net
income instead of the present value of the near-term cash flows for the first part of the
 Hock P2 2020
Section B - Corporate Finance.
Answers
calculation, and (2) using the undiscounted value of the terminal, or horizon, value of
the company at the end of the four-year period instead of its present value.
Explanation for Choice C:
The valuation for Bright Screens consists of two pieces: the present value of the near-
term cash flows (for the next four years) and the present value of the terminal, or
horizon, value of the company at the end of that four-year period.
This answer results from using the present value of the near-term net income instead of
the present value of the near-term cash flows for the first part of the calculation.
Explanation for Choice D:
The valuation for Bright Screens consists of two pieces: the present value of the near-
term cash flows (for the next four years) and the present value of the terminal, or
horizon, value of the company at the end of that four-year period.
This answer results from using the undiscounted value of the terminal, or horizon, value
of the company at the end of the four-year period instead of its present value.
371. Question ID: CMA 1296 1.26 (Topic: Corporate Restructuring)
An example of a "poison pill," a form of takeover defense, is

 A. The act of substantially increasing a company's debt.

 B. The selling off of profitable units in an attempt to dissuade the hostile corporate raider.
 C. An agreement to buy back from the hostile raider a large block of stock at a premium.
 D. The issuance of rights that allow shareholders to purchase stock in the proposed
merged company at a substantial discount.correct
Question was not answered
Correct Answer Explanation:
Poison pills are provisions in a company's corporate charter, bylaws or contracts that
serve to reduce the value of the firm as a potential takeover target. Rights that allow
shareholders to purchase stock in the proposed merged company at a substantial
discount would be considered a poison pill defense. Because of the potential dilution of
ownership through this discounted sale of shares, the company would be less attractive
as a takeover target and an acquiring company will be less likely to want to buy the
company.
Explanation for Choice A:
Poison pills are provisions in a company's corporate charter, bylaws or contracts that
serve to reduce the value of the firm as a potential takeover target. Increasing the debt
of the company is not a poison pill defense.
Explanation for Choice B:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Poison pills are provisions in a company's corporate charter, bylaws or contracts that
serve to reduce the value of the firm as a potential takeover target. Selling off of
profitable units is ot a poison pill defense. It is, rather, the definition of a crown jewel
defense mechanism.
Explanation for Choice C:
Poison pills are provisions in a company's corporate charter, bylaws or contracts that
serve to reduce the value of the firm as a potential takeover target. An agreement to buy
back a large block of stock at a premium from a hostile raider is the definition of the
greenmail defense from takeovers.
372. Question ID: CIA 593 IV.59 (Topic: Corporate Restructuring)
If a company is experiencing cash flow problems, it will most likely attempt a
reorganization involving

 A. Replacing some of the common stock outstanding with debt.

 B. Replacing some of the debt outstanding with preferred stock.
 C. Replacing some of the common stock outstanding with preferred stock.
 D. Replacing some of the debt outstanding with common stock.correct
Question was not answered
Correct Answer Explanation:
If the company is having cash flow problems, it will want to change its financing to
common stock. This is because debt must have the interest paid every period, even
when there are poor cash flows. Common stock does not need to have dividends paid
every period. Common stock is better than preferred stock in this situation because the
preferred stock dividends are often earned (if the preferred stock is cumulative), even if
they are not paid. Preferred stock would place a secondary cash burden on the
company because these dividends will need to be paid at some point in the future.
Explanation for Choice A:
Replacing common stock with debt is the opposite of what the company should do
because debt requires a payment of interest each period and ultimately repayment of
the principal. Common stock does not require the payment of dividends each period.
Explanation for Choice B:
While the replacement of debt with preferred stock is a step in the right direction,
replacing the debt with common stock would be better than preferred stock because
preferred stock may have cumulative dividends that are earned every period, even if
they are not paid.
Explanation for Choice C:
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Section B - Corporate Finance.
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In a situation in which the company has poor cash flows, common stock is the best
source of financing because there are no required dividend payments and the dividends
do not accumulate for common shares like they may with preferred shares.
373. Question ID: ICMA 19.P2.087 (Topic: Corporate Restructuring)
A corporation would receive cash if it enters into a(n)

 A. equity carve-out divestiture.correct

 B. spin-off divestiture.
 C. reverse stock split program.
 D. stock repurchase program.
Question was not answered
Correct Answer Explanation:
In an equity carve-out divestiture, the parent company usually retains the majority of the
stock in the carved-out new company and sells only part of the new company’s stock.
The equity carve-out is a form of equity financing with the cash going to the original
(parent) company.
Explanation for Choice B:
In a spin-off divestiture, the original company does not receive any cash. The part of the
company that is spun-off receives the cash from the issuance of shares.
Explanation for Choice C:
In a reverse stock split, the company does not receive any cash.
Explanation for Choice D:
In a stock repurchase program, the company does not receive any cash.
374. Question ID: ICMA 13.P2.034 (Topic: Corporate Restructuring)
BigCo, a large conglomerate, has a division that has developed a new and highly
promising technology. BigCo would like to retain control of this division, but also raise
additional capital to support the further development of this technology. BigCo also
realizes this promising technology is different than its usual business lines and will
require a new management style and incentive program to attract and maintain talent.
Which one of the following would best allow BigCo to achieve these objectives?

 A. A spin-off of the division.

 B. Sale of the division to another firm.
 C. A management buy-out of the division.
 D. An equity carve-out of the division.correct
Question was not answered
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Correct Answer Explanation:
An equity carve-out would best accomplish BigCo's objectives. The shares in the new
company would be sold in an initial public offering, which would generate new capital.
Furthermore, BigCo could retain majority control of the new company, because usually
the parent company sells only part of the stock in the carved-out new company. As
majority stockholder in the new company, BigCo can reward managers based on the
stock's performance, which can serve as an incentive to attract and retain managerial
talent.
Explanation for Choice A:
A spinoff could give incentives to management of the spun-off unit because managers
could be given stock or stock options in the new company. However, a spinoff would not
raise the new capital that is needed.
Explanation for Choice B:
Sale of the division to another firm would not achieve any of BigCo's objectives. It would
not create additional capital to support the further development of the technology. BigCo
would not retain control of the division, and there would be no incentive program that
BigCo could control that could attract and retain managerial talent.
Explanation for Choice C:
A management buy-out of the division would not achieve any of BigCo's objectives. It
would not create additional capital to support the further development of the technology.
BigCo would not retain control of the division, and there would be no incentive program
that BigCo could control that could attract and retain managerial talent.
375. Question ID: ICMA 1603.P2.007 (Topic: Corporate Restructuring)
A publicly-traded company is planning to divest its Division A for $100 million. Private
investors have pooled their capital of $10 million and plan to finance the balance of $90
million via debt financing with Division A's assets as collateral. The new owners plan to
give the new management a bigger stake in the company by providing stock options.
They also redesigned performance measures and incentive schemes for employees to
minimize inefficiencies and bureaucracy. This scenario most closely describes a

 A. leveraged buyout.correct
 B. leveraged recapitalization.
 C. management buyout.
 D. management recapitalization.
Question was not answered
Correct Answer Explanation:
This scenario most closely describes a leveraged buyout. A leveraged buyout is a
method of financing the purchase of a company or a segment of a company using very
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little equity. A large proportion of the purchase price offered is financed with large
amounts of debt. The company or segment being purchased is the borrower, and its
assets are the collateral for the debt that finances the purchase. The business unit
involved nearly always becomes a private company.
The leveraged buyout may come about because a company wants to divest itself of a
division. Alternatively, an entire company may be purchased in a leveraged buyout. The
buyers of the division or company may or may not be the existing management.
Explanation for Choice B:
A leveraged recapitalization is an anti-takeover strategy. It is performed to make the
target company less financially attractive as a potential takeover.
The company takes on a significant amount of additional debt and uses it to pay a large
cash dividend to shareholders and/or to repurchase shares of its own stock.
As a result of the strategy, the company's liabilities are increased and its equity is
reduced. This strategy is an intentional anti-takeover measure used to make the
corporation less attractive to potential acquirers because of the increased debt and
decreased equity.
This would not be considered a leveraged recapitalization.
Explanation for Choice C:
The new owner(s) may or may not be members of current management. We know the
current managers will not be the new managers, because the question says "The new
owners plan to give the new management a bigger stake in the company by providing
stock options." Therefore, this would not be considered a management buyout.
Explanation for Choice D:
A management recapitalization usually takes place with a privately-held company that is
managed by its owner(s), and a new investor, usually a private equity firm, makes a
new investment and participates as either a majority or a minority owner. Existing
management retains significant ownership. In this situation, the seller is a publicly-
owned company, and it is divesting itself of a division. The managers of the division are
not the owners. The divested division will have completely new owners and completely
new management. Therefore, this is not a management recapitalization.
376. Question ID: CMA 1287 1.28 (Topic: International Finance)
If the value of the U.S. dollar in foreign currency markets changes from $1 = 1.15 Swiss
francs to $1 = 0.95 Swiss francs,

 A. U.S. exports to Switzerland should decrease.

 B. The Swiss franc has depreciated against the dollar.
 C. U.S. tourists in Switzerland will find their dollars will buy more Swiss products.
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 D. Swiss imported products in the U.S. will become more expensive.correct
Question was not answered
Correct Answer Explanation:
Because one dollar now buys fewer francs, the price of Swiss products in the U.S. will
increase. This is because a U.S. consumer needs to spend more dollars to buy the
required number of francs to purchase the good.
Explanation for Choice A:
Because the Swiss franc now buys more dollars, U.S. exports to Switzerland will
increase as the prices of U.S. exported goods to Switzerland decrease.
Explanation for Choice B:
The Swiss franc has appreciated against the dollar as it takes fewer francs to buy one
dollar.
Explanation for Choice C:
Because one dollar now buys fewer francs, U.S. tourists in Switzerland will be able to
buy less with their dollars.
377. Question ID: CMA 1288 1.17 (Topic: International Finance)
Caroline Brown, the product manager for a U.S. computer manufacturer, is being asked
to quote prices of desktop computers to be used in Kuwait. The Kuwaiti government
wants the price in British pounds, for delivery next year. Brown knows that the general
price level in the United States will increase by 3%. Her banker forecasts that the British
pound will depreciate about 5% this year with respect to the U.S. dollar. If Brown is able
to quote 700 pounds for immediate delivery, the price that should be quoted for delivery
to Kuwait next year is about

 A. £757.
 B. £737.
 C. £721.
 D. £759.correct
Question was not answered
Correct Answer Explanation:
In order to determine the price to quote, Caroline needs to take into account the price
level increase in the U.S. and also the depreciation of the pound. Both of these will
increase the number of pounds that need to be quoted in the price. The price to be
quoted is calculated as follows: £700 × <(1 + 0.03) × [1 / (1 − 0.05)]> or £700 × (1.03 /
0.95) = £758.95 or £759.
To look at this another way:
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Let's assume that today, the exchange rate between the British pound and the U.S.
dollar is £1 = $1.6094 US. So £700 today would be equal to $1,126.58 US (700 ×
1.6094).
Inflation in the U.S. is expected to be 3%. Therefore, $1,126.58 today = $1,160.38 one
year from now ($1,126.58 × 1.03).
The British pound is expected to depreciate 5% this year with respect to the U.S. dollar.
That means the British pound will buy 5% less in U.S. dollars one year from now. If £1
today buys $1.6094 US, 5% less than that is $1.52893 ($1.6094 × 0.95).
The amount of British pounds the company will need to receive one year from today in
order to be able to convert it into $1,160.38 US at the exchange rate of £1 = $1.52893
US is £758.95 ($1,160.38 / $1.52893).
Explanation for Choice A:
This is £700 × 1.03 × 1.05. Instead of multiplying by 1.05, we need to divide by 0.95 (1 −
0.05). See the correct answer for a complete explanation.
Explanation for Choice B:
This answer takes into account only the depreciation of the pound. The increase in the
price level must also be taken into consideration.
Explanation for Choice C:
This answer takes into account only the increase in the price level. The depreciation of
the pound must also be taken into consideration.
378. Question ID: CMA 1287 1.29 (Topic: International Finance)
If consumers in Japan decide they would like to increase their purchases of consumer
products made in the United States, in foreign currency markets there will be a
tendency for:

 A. The supply of dollars to increase.

 B. The supply of dollars to decrease.
 C. The Japanese yen to appreciate relative to the U.S. dollar.
 D. The demand for dollars to increase.correct
Question was not answered
Correct Answer Explanation:
In order to purchase more goods made in the U.S., Japanese consumers will need to
buy more dollars. This will cause there to be an increase in the supply of yen on
currency markets and an increase in the demand for dollars.
Explanation for Choice A:
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The supply of dollars is unchanged as a result of this demand shift, however the
quantity supplied will increase as the dollar appreciates against the yen because there
will be an increase in the price of the dollar as a result of the increase in demand.
Explanation for Choice B:
The supply of dollars is unchanged as a result of this demand shift, however the
quantity supplied will increase as the dollar appreciates against the yen.
Explanation for Choice C:
As a result of this demand shift the quantity of dollars supplied will increase as the dollar
appreciates against the yen.
379. Question ID: ICMA 1603.P2.054 (Topic: International Finance)
A U.S. company has an account receivable from a Swiss company for 100,000 Swiss
Francs (CHF) due in three months. At the time of contract, the exchange rate was 1.0
CHF = 1.0 USD. The U.S. company wishes to manage its foreign exchange exposure
and therefore

 A. sells a Swiss Franc interest rate swap.

 B. sells Swiss Franc futures.correct
 C. buys Swiss Franc futures.
 D. buys a currency swap.
Question was not answered
Correct Answer Explanation:
The U.S. company will be receiving 100,000 Swiss Francs that it will need to convert
into U.S. dollars. The U.S. company can enter into a futures contract to sell 125,000
Swiss Francs that expires shortly after the due date of its receivable.
When the U.S. company receives 100,000 Swiss Francs in payment of the receivable, it
will close out its futures contract by entering into a contract to buy 125,000 Swiss
Francs with the same expiration date as its original contract, and that will zero out its
contract. The U.S. company will have either a gain or a loss on the futures contract
transactions. The U.S. company will then use its 100,000 Swiss Francs to buy U.S.
dollars on the spot market. The U.S. company may have a foreign currency gain or loss
due to changes in the spot rate since it first issued the invoice, but any gain or loss will
be offset by a loss or gain in a similar amount on the futures contracts. Since the
receivable is for 100,000 Swiss Francs and the futures contracts are for 125,000 Swiss
Francs, the offset will not be exact, but it will be close.
The futures contracts are for 125,000 Swiss Francs because that is the lowest-
denominated Swiss Franc futures contract that is available on U.S. futures exchanges
such as the CME Group (formerly Chicago Mercantile Exchange).
Explanation for Choice A:
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An interest rate swap takes place when two parties exchange interest payments, usually
one at a fixed rate and one at a floating (or variable) rate pegged to some sort of market
rate of interest that changes whenever the market rate changes. One firm exchanges its
fixed rate interest payments for a series of payments on the same principal amount
based on a floating rate instead, and the other firm exchanges its floating rate interest
payments for a series of payments on the same principal amount based on a fixed rate
instead.
An interest rate swap does not involve exchanges in currencies. If a firm wishes to
change the currency in which its debt is denominated, it uses a currency swap. In a
currency swap principal payments are exchanged as well as interest payments. The two
parties swap principal and interest amounts that are in different currencies.
Explanation for Choice C:
The U.S. company will be receiving 100,000 Swiss Francs that it will need to convert
into U.S. dollars. Entering into a futures contract to buy Swiss Francs would not be
helpful.
Explanation for Choice D:
A currency swap would not serve as a hedge for foreign exchange exposure on an
account receivable. A currency swap is a variation on an interest rate swap. With an
interest rate swap, only interest payments are exchanged, because the principal amount
is the same for both parties to the swap. However, in a currency swap principal
payments are exchanged as well as interest payments. The two parties swap principal
and interest amounts that are in different currencies. A currency swap can be used to
change the the currency in which the firm's liabilities are denominated.
380. Question ID: ICMA 10.P2.194 (Topic: International Finance)
Country A's currency would tend to appreciate relative to Country B's currency when

 A. Country A has a slower rate of growth in income that causes its imports to lag behind
its exports.correct
 B. Country B switches to a more restrictive monetary policy.
 C. Country A has a higher rate of inflation than Country B.
 D. Country B has real interest rates that are greater than real interest rates in Country A.
Question was not answered
Correct Answer Explanation:
The increase in exports by Country A will lead to increased demand for Country A's
currency on currency markets (in order to purchase its exports). The increased demand
for its currency will lead to appreciation of Country A's currency.
Explanation for Choice B:
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A more restrictive monetary policy in Country B will cause economic growth in Country
B to slow. This will cause people in Country B to purchase fewer imports from Country
A. The decreased demand for Country A's currency will cause Country A's currency to
depreciate relative to Country B’s currency, not to appreciate.
Explanation for Choice C:
The country that has a higher inflation rate will experience a depreciation of their
currency relative to a country with a lower inflation rate. If Country A has a higher
inflation rate, the currency of Country A will depreciate. This is because the inflation
makes each unit of the currency less valuable.
Explanation for Choice D:
The country that has lower real interest rates will experience a depreciation of their
currency. This is because there will be a higher demand for the currency of the country
that has higher interest rates.
381. Question ID: CMA 1282 1.14 (Topic: International Finance)
Given a spot rate of $1.8655 and a 90-day forward rate of $1.8723, the pound sterling in
the forward market is:

 A. Undervalued.
 B. Being quoted at a premium.correct
 C. Being quoted at a discount.
 D. Overvalued.
Question was not answered
Correct Answer Explanation:
By definition, if the spot rate is less than the forward rate, the currency is said to be
selling at a premium in the forward market.
Explanation for Choice A:
By definition, if the spot rate is less than the forward rate, the currency is said to be
selling at a premium in the forward market. This does not necessarily indicate anything
about the value of the currency.
Explanation for Choice C:
By definition, if the spot rate is less than the forward rate, the currency is said to be
selling at a premium in the forward market.
Explanation for Choice D:
By definition, if the spot rate is less than the forward rate, the currency is said to be
selling at a premium in the forward market. This does not necessarily indicate anything
about the value of the currency.
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382. Question ID: CMA 1287 1.30 (Topic: International Finance)
If the U.S. dollar declines in value relative to the currencies of many of the U.S. trading
partners, the likely result is that

 A. U.S. exports will tend to increase.correct

 B. Foreign currencies will depreciate against the dollar.
 C. The U.S. balance of payments deficit will become worse.
 D. U.S. imports will tend to increase.
Question was not answered
Correct Answer Explanation:
The decrease in the value of the dollar makes U.S. goods relatively less expensive
relative to foreign produced goods and this will increase U.S. exports. This will improve
the U.S. balance of payments deficit.
Explanation for Choice B:
If the U.S. dollar declines in value (depreciates) relative to the currencies, the foreign
currencies must appreciate against the dollar.
Explanation for Choice C:
The decrease in the value of the dollar makes U.S. goods relatively less expensive
relative to foreign produced goods and this will increase U.S. exports. This will improve
the U.S. balance of payments deficit.
Explanation for Choice D:
The decrease in the value of the dollar makes U.S. goods relatively less expensive
relative to foreign produced goods and this will increase U.S. exports. Similarly, the
decline in the value of the dollar will make foreign goods relatively more expensive in
the U.S. and this will decrease imports.
383. Question ID: CMA 1285 1.30 (Topic: International Finance)
The dominant reason countries devalue their currencies is to:

 A. Slow what is regarded as too rapid an accumulation of international reserves.

 B. Improve the balance of payments.correct
 C. Curb inflation by increasing imports.
 D. Discourage exports without having to impose controls.
Question was not answered
Correct Answer Explanation:
The devaluation of a country's currency improves its balance of payments by making
domestic products more attractive to foreign consumers through lower relative prices.
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When the currency is overvalued domestically produced goods are more expensive in
the world market (reducing exports) and foreign produced goods are cheaper
(increasing imports).
Explanation for Choice A:
When a country is maintaining a fixed exchange rate that is lower than the market rate
(the country's currency has been devalued on currency markets), the country will have a
trade surplus. Because its currency is too cheap, or is undervalued, foreigners will buy a
large amount of the country's goods. However, imports will be relatively low because
citizens of the country with the devalued currency will not want to buy goods of other
countries because they will be too expensive. Therefore the citizens of the country with
the devalued currency will not be selling their currency in the currency markets to buy
other countries' currencies. As a result, if the exchange rate were allowed to freely
adjust, the currency of the country with the devalued currency would become more
expensive and it would no longer be cheap or devalued.
In order to maintain the undervalued fixed exchange rate, the government of the country
will need to sell its own currency in the currency markets and buy other currencies. The
result will be an increased accumulation of international reserves by the country with
the devalued currency, which is the opposite of what this answer choice states.
Explanation for Choice C:
The devaluation of a country's currency will decrease imports because it will take more
of the local currency to purchase foreign produced goods.
Explanation for Choice D:
The devaluation of a country's currency encourages exports because the domestically
produced goods are now cheaper when compared to foreign produced goods. This will
increase exports.
384. Question ID: CMA 1288 1.16 (Topic: International Finance)
One U.S. dollar is being quoted at 120 Japanese yen on the spot market and at 123
Japanese yen on the 90-day forward market; hence, the annual effect in the forward
market is that the

 A. U.S. dollar is at a premium of 2.5%.

 B. U.S. dollar is at a discount of 10%.
 C. U.S. dollar is at a premium of 10%.correct
 D. U.S. dollar is at a premium of 0.025%.
Question was not answered
Correct Answer Explanation:
Because the price of the U.S. dollar in the forward market is higher than the price in the
spot market, the U.S. dollar is selling at a premium in the forward market.
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Since the rates given are for 90 days forward, in order to calculate the annual effect, we
will need to calculate the effect for 90 days and then multiply that result by 4.
In annual terms, the premium is calculated as: [((123-120)/120) × 4] = 0.10. This
represents a 10% premium of the U.S. dollar in the forward market.
Explanation for Choice A:
This answer is the effect on the 90-day period given in the two rates. In order to
calculate the annual effect, we will need to multiply this by 4.
Explanation for Choice B:
Because the price of the U.S. dollar in the forward market is higher than the price in the
spot market, the U.S. dollar is selling at a premium in the forward market.
Explanation for Choice D:
This answer results from two errors: (a) (123-120)/120) equals 0.025, which expressed
as a percentage is 2.5%, not 0.025%. And (b) since the rates given are for 90 days
forward, in order to calculate the annual effect, we will need to calculate the effect for 90
days and then multiply that result by 4.
385. Question ID: ICMA 13.P2.013 (Topic: International Finance)
FreezeIt Inc. is a manufacturer of refrigeration systems based out of the United States
with one subsidiary in Canada. The Canadian subsidiary exports all of its manufactured
products to the United States and does not currently sell any of its manufactured
products in Canada. The Canadian subsidiary incurs all of its expenses in Canadian
dollars and all of its revenues are in U.S. dollars. The U.S. operations are conducted
only in U.S. dollars. What financial impact will a rise in the Canadian dollar against the
U.S. dollar have on the Canadian subsidiary assuming no operational changes?

 A. A reduction in revenues.correct
 B. A reduction in expenses.
 C. An increase in profit margins.
 D. An increase in cash flows.
Question was not answered
Correct Answer Explanation:
The question asks what impact a rise in the Canadian dollar against the U.S. dollar will
have on the Canadian subsidiary. Note that it does not ask for the impact on the
consolidated company. Thus there are no issues here with currency conversion for
consolidation purposes.
A rise in the Canadian dollar against the U.S. dollar means that each Canadian dollar is
worth more U.S. dollars. At the same time, each U.S. dollar is worth fewer Canadian
dollars.
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Since the subsidiary earns all of its revenues in U.S. dollars and since a rise in the
Canadian dollar against the U.S. dollar means each U.S. dollar of revenue is worth
fewer Canadian dollars, the financial impact will be a reduction in revenues for the
Canadian subsidiary.
Explanation for Choice B:
The question asks what impact a rise in the Canadian dollar against the U.S. dollar will
have on the Canadian subsidiary. Note that it does not ask for the impact on the
consolidated company. Thus there are no issues here with currency conversion for
consolidation purposes.
Since the Canadian subsidiary incurs all of its expenses in Canadian dollars, a rise in
the Canadian dollar against the U.S. dollar will have no effect on the Canadian
subsidiary's reported expenses.
Explanation for Choice C:
A rise in the Canadian dollar against the U.S. dollar means that each Canadian dollar is
worth more U.S. dollars. At the same time, each U.S. dollar is worth fewer Canadian
dollars.
Since the subsidiary earns all of its revenues in U.S. dollars and since a rise in the
Canadian dollar against the U.S. dollar means each U.S. dollar of revenue is worth
fewer Canadian dollars, the financial impact will be a reduction in revenues for the
Canadian subsidiary.
Since the Canadian subsidiary incurs all of its expenses in Canadian dollars, a rise in
the Canadian dollar against the U.S. dollar will have no effect on the Canadian
subsidiary's reported expenses.
Reduced revenues and unchanged expenses will lead to a decrease in profit margins,
not an increase.
Explanation for Choice D:
A rise in the Canadian dollar against the U.S. dollar means that each Canadian dollar is
worth more U.S. dollars. At the same time, each U.S. dollar is worth fewer Canadian
dollars.
Since the subsidiary earns all of its revenues in U.S. dollars and since a rise in the
Canadian dollar against the U.S. dollar means each U.S. dollar of revenue is worth
fewer Canadian dollars, the financial impact will be a reduction in cash inflows for the
Canadian subsidiary when it exchanges the U.S. dollars for Canadian dollars.
Since the Canadian subsidiary incurs all of its expenses in Canadian dollars, a rise in
the Canadian dollar against the U.S. dollar will have no effect on the Canadian
subsidiary's cash outflows for operating expenses.
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Since inflows will be reduced and outflows will not be affected, the net effect of the
change in the exchange rate will be a decrease in net cash flows, not an increase.
386. Question ID: CIA 1196 IV.64 (Topic: International Finance)
A company has a foreign-currency-denominated trade payable, due in 60 days. In order
to eliminate the foreign currency exchange-rate risk associated with the payable, the
company could

 A. Borrow foreign currency today, convert it to domestic currency on the spot market, and
invest the funds in a domestic bank deposit until the invoice payment date.
 B. Wait 60 days and pay the invoice by purchasing foreign currency in the spot market at
that time.
 C. Buy foreign currency forward today.correct
 D. Sell foreign currency forward today.
Question was not answered
Correct Answer Explanation:
If a firm buys a forward contract, it is in a position to buy the foreign currency when it is
needed in the future, but at the price specified today. Hence the firm's payables are
covered by this fixed-cost foreign currency as they will know the amount of the domestic
currency that will be required to settle the foreign currency denominated payable. This
will eliminate the exchange rate risk of the rates moving in the wrong direction prior to
the need for the foreign currency.
Explanation for Choice A:
Though this will settle the liability, it does not protect the company from the exchange
rate risk. The exchange rate risk is the risk that the exchange rate will move in the
wrong direction and require more of the local currency to settle the amount.
Explanation for Choice B:
Though this will settle the liability, it does not protect the company from the exchange
rate risk. The exchange rate risk is the risk that the exchange rate will move in the
wrong direction and require more of the local currency to settle the amount.
Explanation for Choice D:
The firm will need to buy the foreign currency in the future so that they do not need to
sell foreign currency today.
387. Question ID: CMA 676 1.34 (Topic: International Finance)
Which of the following economic policies would not tend to correct a balance of
payments deficit in the U.S.?

 A. Increase value of U.S. currency in relation to foreign currencies.correct

 B. A reduction in the economic aid and humanitarian aid provided to other nations.
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 C. More effective use of monetary and fiscal policies to reduce inflation.
 D. Increase productivity in the manufacturing of U.S. exports.
Question was not answered
Correct Answer Explanation:
An increase in the value of U.S. currency will raise the comparative price of U.S.
products. This will reduce the volume of U.S. exports and increase imports as the
relative price of U.S. goods increases. Thus the balance of payments deficit
will increase, not decrease, if the value of the U.S. currency increases.
Explanation for Choice B:
A reduction of economic and humanitarian aid is a reduction of unilateral transfers out of
the U.S., thus reducing the balance of payments deficit.
Explanation for Choice C:
A reduction of inflation will lower U.S. goods prices relative to foreign prices. As a result,
U.S. exports will increase, reducing the balance of payments deficit.
Explanation for Choice D:
Increased productivity in the manufacture of U.S. exports would reduce the relative
price of U.S. export goods compared to other goods. This would decrease a balance of
payments deficit.
388. Question ID: CMA 1288 1.15 (Topic: International Finance)
The U.S. dollar has a free-floating exchange rate. When the dollar has fallen
considerably in relation to other currencies, the

 A. Trade account in the U.S. balance of payments is neither in a deficit nor in a surplus
because of the floating exchange rates.
 B. Capital account in the U.S. balance of payments is neither in a deficit nor in a surplus
because of the floating exchange rates.
 C. Fall in the dollar's value cannot be expected to have any effect on the U.S. trade
balance.
 D. Cheaper dollar helps U.S. exporters of domestically produced goods.correct
Question was not answered
Correct Answer Explanation:
The price of U.S. goods to buyers in other countries will fall as a result of the cheaper
U.S. dollar because a citizen of a foreign country will need fewer units of their currency
to buy the necessary dollars to import the U.S. goods. Because prices of U.S. goods are
lower, the quantity demanded of U.S. exported goods will increase.
Explanation for Choice A:
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The trade account could be in either a deficit or surplus regardless of the value of the
U.S. dollar.
Explanation for Choice B:
The capital account could be in either a deficit or surplus regardless of the value of the
U.S. dollar.
Explanation for Choice C:
Since the price of U.S. goods will fall relative to foreign goods, U.S. exports will increase
which will push the trade balance toward a surplus.
389. Question ID: CMA 1282 1.12 (Topic: International Finance)
One may characterize the current international monetary system developed by the
industrialized countries as a

 A. managed or dirty float. Central banks intervene in the foreign exchange market to
influence the exchange rates.correct
 B. clean float. Freely floating exchange rates are determined solely by the forces of
demand and supply.
 C. stable-rate system.
 D. gold-based system.
Question was not answered
Correct Answer Explanation:
Industrialized nations use a managed float. Under the managed float system, the
exchange rates are determined by the market, but the government also sells and buys
currency in order to influence the exchange rate.
Explanation for Choice B:
Industrialized nations use a managed float. Under the managed float system, the
exchange rates are determined mainly by the market, but the government also sells and
buys currency in order to influence the exchange rate. In a clean float there is no
governmental intervention.
Explanation for Choice C:
Industrialized nations use a managed float. Under the managed float system, the
exchange rates are determined by the market, but the government also sells and buys
currency in order to influence the exchange rate. In a stable rate system, the
government would establish a fixed rate and then enter into various transactions to
maintain that rate.
Explanation for Choice D:
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Industrialized nations use a managed float. Under the managed float system, the
exchange rates are determined by the market, but the government also sells and buys
currency in order to influence the exchange rate. In a gold-based system the currency is
backed by gold. This system has not been in use for a number of decades.
390. Question ID: ICMA 10.P2.195 (Topic: International Finance)
Country R's currency would tend to depreciate relative to Country T's currency when

 A. Country T has a rapid rate of growth in income that causes imports to lag behind
exports.
 B. Country R has a rate of inflation that is lower than the rate of inflation in Country T.
 C. Country R switches to a more restrictive monetary policy.
 D. Country R has real interest rates that are lower than real interest rates in Country
T.correct
Question was not answered
Correct Answer Explanation:
If real interest rates are higher in Country T than in Country R, more people will want to
invest in Country T. This will cause the demand for Country T's currency to increase,
and that will lead to appreciation of Country T's currency relative to Country R's
currency. When Country T's currency appreciates relative to Country R's currency,
Country R's currency depreciates relative to Country T's currency.
Explanation for Choice A:
A rapid rate of growth in income in Country T would not cause imports to lag behind
exports. It would cause the opposite – imports into Country T would be greater than
Country T’s exports. The increased demand for imports from Country R would cause
Country R's currency to appreciate relative to Country T's currency, not depreciate.
Explanation for Choice B:
If inflation in Country R is lower than inflation in Country T, more people in Country T will
want to buy Country R’s goods, because they will cost relatively less. The increased
demand for Country R's goods will lead to increased demand for its currency. The
increased demand for its currency will lead to appreciation of Country R's currency
relative to Country T's currency, not depreciation.
Explanation for Choice C:
A more restrictive monetary policy in Country R will cause economic growth in Country
R to slow. This will cause people in Country R to purchase fewer imports from Country
T. The decreased demand for Country T’s currency will cause Country T’s currency to
depreciate relative to Country R's currency, and, at the same time, Country R's currency
will appreciate relative to Country T's currency, not depreciate.
391. Question ID: CMA 694 1.4 (Topic: International Finance)
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If the central bank of a country raises interest rates sharply, the country's currency will
most likely

 A. Decrease sharply in value at first and then return to its initial value.
 B. Remain unchanged in value.
 C. Decrease in relative value.
 D. Increase in relative value.correct
Question was not answered
Correct Answer Explanation:
The increase in interest rates will attract foreign funds to domestic assets. This will
increase the value of the domestic currency as demand for the currency increases.
Explanation for Choice A:
The increase in interest rates will attract foreign funds to domestic assets. This will
increase the value of the domestic currency as demand for the currency increases.
Explanation for Choice B:
The increase in interest rates will attract foreign funds to domestic assets. This will
increase the value of the domestic currency as demand for the currency increases. Any
change in the interest rate by the central bank will impact the value of the country's
currency.
Explanation for Choice C:
The increase in interest rates will attract foreign funds to domestic assets. This will
increase the value of the domestic currency as demand for the currency increases.
392. Question ID: CMA 690 5.11 (Topic: International Finance)
A bill of lading is a document that

 A. Summarizes data relating to a disbursement and represents final authorization for

payment.
 B. Is sent with the goods giving a listing of the quantities of items included in the shipment.
 C. Is used to transfer responsibility for goods between the seller of goods and a common
carrier.correct
 D. Reduces a customer's account for goods returned to the seller.
Question was not answered
Correct Answer Explanation:
A bill of lading is a document that transfers possession of goods from the seller to a
common carrier.
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Explanation for Choice A:
The description given is related to a payment order, not a bill of lading.
Explanation for Choice B:
The description given is that of a packing slip, not a bill of lading.
Explanation for Choice D:
The description is given is that of a credit memo, not a bill of lading.
393. Question ID: CMA 680 1.17 (Topic: International Finance)
The value of the U.S. dollar in relation to other foreign currencies is

 A. Determined by the forces of supply and demand on the foreign exchange

markets.correct
 B. Set by the U.S. government in consultation with other foreign governments.
 C. Determined directly by the price of gold because the value of the U.S. dollar is tied to
the price of gold.
 D. Set along with the value of other currencies held by the International Monetary Fund.
Question was not answered
Correct Answer Explanation:
The U.S. exchange rates in relation to other currencies are floating rates determined by
the forces of supply and demand.
Explanation for Choice B:
This is the characteristic of a fixed exchange rate. The U.S. exchange rates in relation
to other currencies are floating rates determined by the forces of supply and demand.
Explanation for Choice C:
The value of the U.S. dollar is not tied to the price of gold, but is rather a floating
exchange rate.
Explanation for Choice D:
This is the characteristic of a fixed exchange rate. The U.S. exchange rates in relation
to other currencies are floating rates determined by the forces of supply and demand.
394. Question ID: CMA 688 1.23 (Topic: International Finance)
If risk is purposely undertaken in the foreign currency market, the investor in foreign
currency then becomes

 A. A speculator.correct
 B. Involved in hedging.
 C. An arbitrageur.
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 D. An exporter.
Question was not answered
Correct Answer Explanation:
By definition, speculators engage in risky trades in the hope of earning a quick, large
profit.
Explanation for Choice B:
Speculators engage in risky trades in the hope of earning a quick, large profit. Hedging
is a way to avoid risk in the foreign currency market.
Explanation for Choice C:
An arbitrageur is an investor who attempts to profit from price inefficiencies in the
market by making simultaneous trades that offset each other and thus earning risk-free
profits. For example, arbitrageurs seek price discrepancies between the listing of a
security on one exchange and the listing of the same security on another exchange and
buy and sell the same security on the two different exchanges in order to make a small
profit on the difference.
Explanation for Choice D:
Speculators engage in risky trades in the hope of earning a quick, large profit. An
exporter is involved in the sale of goods or services to foreign consumers and uses the
foreign exchange market to facilitate its sales.
395. Question ID: CIA 592 IV.70 (Topic: International Finance)
A short-term speculative rise in the world-wide value of domestic currency could be
moderated by a central bank decision to

 A. Sell foreign currency in the foreign exchange market.

 B. Sell domestic currency in the foreign exchange market.correct
 C. Increase domestic interest rates.
 D. Buy domestic currency in the foreign exchange market.
Question was not answered
Correct Answer Explanation:
Currency exchange rates are subject to the law of supply and demand. A speculative
rise in the value of the domestic currency is caused by an increased demand for the
domestic currency. The sale of domestic currency in foreign exchange markets will
increase the supply of the domestic currency in the foreign exchange markets, which
will lower the price of the domestic currency.
Explanation for Choice A:
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A speculative rise in the value of the domestic currency is caused by an increased
demand for the domestic currency. If the central bank sells foreign currency in the
foreign exchange market, it must buy some other currency at the same time (because it
must receive some currency as payment for the currency it has sold). If the other
currency it buys is its own domestic currency, the result will be a further rise in the
market value of the domestic currency because currency exchange rates are subject to
the law of supply and demand.
If the central bank sells one foreign currency and buys another foreign currency at the
same time, the transaction by the central bank will not impact the value of the domestic
currency.
Explanation for Choice C:
Currency exchange rates are subject to the law of supply and demand. A speculative
rise in the value of the domestic currency is caused by an increased demand for the
domestic currency. Increasing interest rates will cause the demand for domestic
currency to rise even more as more funds enter the domestic economy to take
advantage of the higher interest rates.
Explanation for Choice D:
Currency exchange rates are subject to the law of supply and demand. A speculative
rise in the value of the domestic currency is caused by an increased demand for the
domestic currency. If the central bank buys the domestic currency this will further
increase the demand and further drive up the price of the currency.
396. Question ID: CMA 1288 1.18 (Topic: International Finance)
Consider a world consisting of only two countries, Canada and the United Kingdom.
Inflation in Canada in 1 year was 5%, and in the United Kingdom it was 10%. Which one
of the following statements about the Canadian exchange rate (rounded) with the U.K.
pound sterling during that year will be true?

 A. Inflation has no affect on the exchange rates.

 B. The Canadian dollar will depreciate by 5% against the pound sterling.
 C. The Canadian dollar will depreciate by 15% against the pound sterling.
 D. The Canadian dollar will appreciate by 5% against the pound sterling.correct
Question was not answered
Correct Answer Explanation:
The appreciation of the Canadian dollar is equal to the difference between the United
Kingdom inflation rate (10%) and the Canadian inflation rate (5%). Because the U.K.
inflation rate was higher than the Canadian inflation rate, the Canadian currency has
kept more of its value and has appreciated against the U.K. currency.
Explanation for Choice A:
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Both of these inflation rates will affect the exchange rate between the currencies of the
two countries. The appreciation of the Canadian dollar is equal to the difference
between the United Kingdom inflation rate and the Canadian inflation rate.
Explanation for Choice B:
The appreciation of the Canadian dollar is equal to the difference between the U.K.
inflation rate and the Canadian inflation rate. Though the difference is 5%, the Canadian
currency has appreciated because the inflation in Canada was lower than the U.K.
inflation and the Canadian currency has kept more of its value.
Explanation for Choice C:
The Canadian currency has actually appreciated in value because the inflation rate in
Canada was less than the inflation rate in the U.K. The amount by which the Canadian
currency has appreciated is the difference between the inflation rates in the two
countries.
397. Question ID: CIA 1196 IV.73 (Topic: International Finance)
If the exchange rate has changed from 1 U.S. dollar being worth 0.75 euro to a rate of 1
U.S. dollar being worth 0.90 euro,

 A. The U.S. dollar has depreciated by 20%.

 B. The euro has depreciated by 10%.
 C. The U.S. dollar has appreciated by 20%.correct
 D. The euro has appreciated by 10%.
Question was not answered
Correct Answer Explanation:
Because one U.S. dollar buys more euro than previously, the dollar has appreciated.
The appreciation amount is calculated as follows: [(0.90 − 0.75) / 0.75] = 0.20 or a 20%
appreciation.
Explanation for Choice A:
Because one U.S. dollar buys more euro than previously, the dollar has appreciated,
not depreciated.
Explanation for Choice B:
Though the euro has depreciated in value, it has not depreciated by 10%.
Explanation for Choice D:
Because one U.S. dollar buys more euro than previously, the euro has depreciated, not
appreciated.
398. Question ID: ICMA 19.P2.089 (Topic: International Finance)
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A firm involved in major international market trading can best minimize foreign
exchange risk by

 A. factoring in the cost of interest in the commodity price.

 B. requiring collect on delivery payment from customers to avoid exchange rate
fluctuations.
 C. entering into a forward rate contract.correct
 D. having customers use the spot rate.
Question was not answered
Correct Answer Explanation:
Entering into a forward rate contract would be the best way for a trading company
to best minimize foreign exchange risk.
Explanation for Choice A:
Factoring in the cost of interest in the commodity price would not be the best way for a
trading company to best minimize foreign exchange risk.
Explanation for Choice B:
Requiring collect on delivery payment from customers to avoid exchange rate
fluctuations would not be the best way for a trading company to best minimize foreign
exchange risk.
Explanation for Choice D:
Having customers use the spot rate would not be the best way for a trading company
to best minimize foreign exchange risk.
399. Question ID: ICMA 08.P1.96 (Topic: International Finance)
Which one of the following is least likely to be a reason why U.S. multinational
corporations utilize the foreign exchange market?

 A. To hedge the currency risk of accounts receivable transactions in foreign currencies.

 B. To improve the return on investments of a foreign subsidiary.correct
 C. To offset accounts payable transaction exposure to foreign firms.
 D. To counter some of the currency risk of dividend payments from foreign subsidiaries to
the U.S. parent.
Question was not answered
Correct Answer Explanation:
Though U.S. multinationals use the foreign currency market for a number of reasons,
this is not one of the reasons. The foreign currency markets will not enable the company
to improve the return on the investment of a foreign subsidiary. Assuming that the
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foreign subsidiary's return on investments would involve cash inflows and outflows in
the foreign subsidiary's currency only, those cash flows would not be subject to
exchange rate risk.
Explanation for Choice A:
U.S. multinational companies use the foreign exchange market for many reasons. One
of those reasons is so that they can hedge their receivables that are going to be
collected in a foreign currency. By using foreign currency markets the company can
reduce, or eliminate, the chance of great losses due to the fluctuation of the exchange
rates
Explanation for Choice C:
U.S. multinational companies use the foreign exchange market for many reasons. One
of those reasons is so that they can hedge their payables that are due in a foreign
currency. By using foreign currency markets the company can reduce, or eliminate, the
chance of great losses due to the fluctuation of the exchange rates.
Explanation for Choice D:
U.S. multinational companies use the foreign exchange market for many reasons. One
of those reasons is to reduce the risk of devaluation of dividend payments as a result of
fluctuations of the exchange rate.
400. Question ID: CMA 688 1.25 (Topic: International Finance)
In foreign currency markets, the phrase "managed float" refers to the

 A. Fact that actual exchange rates are set by private business people in trading nations.
 B. Tendency for most currencies to depreciate in value.
 C. Discretionary buying and selling of currencies by central banks.correct
 D. Necessity of maintaining a highly liquid asset, such as gold, to conduct international
trade.
Question was not answered
Correct Answer Explanation:
Under the managed float system, the exchange rates are determined by the market, but
the government also sells and buys currency through its central bank in order to
influence the exchange rate.
Explanation for Choice A:
Under the managed float system, the exchange rates are determined by the market, but
the government also sells and buys currency in order to influence the exchange rate.
Explanation for Choice B:
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Under the managed float system, the exchange rates are determined by the market, but
the government also sells and buys currency in order to influence the exchange rate.
This does not mean that most currencies will depreciate.
Explanation for Choice D:
Under the managed float system, the exchange rates are determined by the market, but
the government also sells and buys currency in order to influence the exchange rate.
This does not require a nation to maintain highly liquid assets.
401. Question ID: ICMA 10.P2.193 (Topic: International Finance)
If the U.S. dollar appreciated against the British pound, other things being equal, we
would expect that

 A. U.S. demand for British products would decrease.

 B. the British demand for U.S. products would increase.
 C. U.S. demand for British products would increase.correct
 D. trade between the U.S. and Britain would decrease.
Question was not answered
Correct Answer Explanation:
If the dollar appreciates against the pound, that means that $1 will buy more British
pounds than previously. This will make British goods comparatively cheaper for
Americans and American goods comparatively more expensive for Brits. Therefore,
Americans will buy more British goods because they need to spend fewer dollars to buy
the British goods.
Explanation for Choice A:
If the dollar appreciates against the pound, that means that $1 will buy more British
pounds than previously. This will make British goods comparatively cheaper for
Americans and American goods comparatively more expensive for Brits. Therefore,
Americans will buy more British goods because they need to spend fewer dollars to buy
the British goods.
Explanation for Choice B:
If the dollar appreciates against the pound, that means that $1 will buy more British
pounds than previously and £1 will buy fewer U.S. dollars than previously. This will
make British goods comparatively cheaper for Americans and American goods
comparatively more expensive for Brits. Therefore, there would be a decrease, not an
increase, in British demand for American goods because a Brit needs more pounds to
buy the American goods.
Explanation for Choice D:
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The appreciation or depreciation of a currency will not cause the level of trade to
increase or decrease. It may change the direction of the trade – in this case more
Americans buying British goods and fewer Brits buying American goods, but the level of
trade will not be affected by this.
402. Question ID: CMA 1285 1.33 (Topic: International Finance)
The purchasing-power parity exchange rate

 A. holds constant the relative price levels in two countries when measured in a common
currency.correct
 B. is a fixed (pegged) exchange rate.
 C. is always equal to the market exchange rate.
 D. results in an undervalued currency of countries that are net importers.
Question was not answered
Correct Answer Explanation:
The purchasing power parity exchange rate is the exchange rate that would ensure that
goods are sold at the same relative price in different countries. This means that if the
PPP exchange rate is in effect and you are able to purchase something in country A for
$20, you could take $20 to country B, exchange the $20 into the local currency and buy
the same good in country B with the $20 you changed. Note that this is a theoretical
rate.
Explanation for Choice B:
The purchasing power parity exchange rate is the exchange rate that would ensure that
goods are sold at the same relative price in different countries. This rate is not fixed
rate.
Explanation for Choice C:
The purchasing power parity exchange rate is the exchange rate that would ensure that
goods are sold at the same relative price in different countries. This rate does not
always equal the market rate.
Explanation for Choice D:
The purchasing power parity exchange rate is the exchange rate that would ensure that
goods are sold at the same relative price in different countries. This rate does not lead
to undervalued currency in net importing countries.
403. Question ID: ICMA 13.P2.036 (Topic: International Finance)
Suppose that Swiss wrist watches priced in Swiss Francs become very popular among
U.S. consumers while at the same time Britain experiences relatively higher inflation
than the United States. Assuming that all other economic parameters remain constant,
which one of the following statements is most accurate?
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 A. The U.S. dollar will depreciate relative to the Swiss Franc and appreciate relative to the
British pound.
correct
 B. The U.S. dollar will depreciate relative to both the Swiss Franc and the British pound.
 C. The U.S. dollar will appreciate relative to the Swiss Franc and depreciate relative to the
British pound.
 D. The U.S. dollar will appreciate relative to both the Swiss Franc and the British pound.
Question was not answered
Correct Answer Explanation:
The increased demand in the U.S. for Swiss watches will create an increased demand
for Swiss francs purchased with U.S. dollars on foreign exchange markets. The result of
the increased demand will be that the Swiss franc will appreciate relative to the U.S.
dollar. At the same time, the increased supply of U.S. dollars on foreign exchange
markets will cause the U.S. dollar to depreciate relative to the Swiss franc.
U.S. dollars will be able to buy fewer goods and services from Britain due to the inflation
in Britain that is greater than inflation in the U.S. That will cause demand in the U.S. for
British goods and services to decrease. The decrease in demand for British goods and
services will cause demand for British pounds purchased in U.S. dollars to decrease.
The decrease in demand for the British pound will cause the British pound to depreciate
relative to the U.S. dollar. At the same time, the U.S. dollar will appreciate relative to the
British pound.
Explanation for Choice B:
The U.S. dollar will appreciate relative to the British pound, not depreciate. U.S. dollars
will be able to buy fewer goods and services from Britain due to the inflation in Britain
that is greater than inflation in the U.S. That will cause demand in the U.S. for British
goods and services to decrease. The decrease in demand for British goods and
services will cause demand for British pounds purchased in U.S. dollars to decrease.
The decrease in demand for the British pound will cause the British pound to depreciate
relative to the U.S. dollar. At the same time, the U.S. dollar will appreciate relative to the
British pound.
Explanation for Choice C:
The U.S. dollar will depreciate relative to the Swiss franc, not appreciate. The increased
demand in the U.S. for Swiss watches will create an increased demand for Swiss francs
purchased with U.S. dollars on foreign exchange markets. The result will be that the
Swiss franc will appreciate relative to the U.S. dollar and at the same time, the U.S.
dollar will depreciate relative to the Swiss franc.
The U.S. dollar will appreciate relative to the British pound, not depreciate. U.S. dollars
will be able to buy fewer goods and services from Britain due to the inflation in Britain
that is greater than inflation in the U.S. That will cause demand in the U.S. for British
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goods and services to decrease. The decrease in demand for British goods and
services will cause demand for British pounds purchased in U.S. dollars to decrease.
The decrease in demand for the British pound will cause the British pound to depreciate
relative to the U.S. dollar. At the same time, the U.S. dollar will appreciate relative to the
British pound.
Explanation for Choice D:
The U.S. dollar will depreciate relative to the Swiss franc, not appreciate. The increased
demand in the U.S. for Swiss watches will create an increased demand for Swiss francs
purchased with U.S. dollars on foreign exchange markets. The result will be that the
Swiss franc will appreciate relative to the U.S. dollar and at the same time, the U.S.
dollar will depreciate relative to the Swiss franc.
404. Question ID: CMA 680 1.20 (Topic: International Finance)
When the U.S. dollar is expected to rise in value against foreign currencies, a U.S.
company with foreign currency denominated receivables and payables should

 A. Speed up collections and speed up payments.

 B. Slow down collections and slow down payments.
 C. Slow down collections and speed up payments.
 D. Speed up collections and slow down payments.correct
Question was not answered
Correct Answer Explanation:
If the U.S. dollar rises in value in the future, U.S. dollars will be worth more relative to
foreign currency and the foreign currency is worth less compared to the dollar.
Therefore the company will want to get as many dollars as possible now so that they will
increase in value while they are being held and the company will want to keep the
dollars that they have to use to pay the foreign denominated payables when the dollar is
stronger. Therefore, they should speed up collections and slow down payments.
Explanation for Choice A:
If the U.S. dollar rises in value in the future, U.S. dollars will be worth more relative to
foreign currency and the foreign currency is worth less compared to the dollar.
Therefore the company will want to get as many dollars as possible now so that they will
increase in value while they are being held and the company will want to keep the
dollars that they have to use to pay the foreign denominated payables when the dollar is
stronger. Therefore, they should speed up collections and slow down payments.
Explanation for Choice B:
If the U.S. dollar rises in value in the future, U.S. dollars will be worth more relative to
foreign currency and the foreign currency is worth less compared to the dollar.
Therefore the company will want to get as many dollars as possible now so that they will
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increase in value while they are being held and the company will want to keep the
dollars that they have to use to pay the foreign denominated payables when the dollar is
stronger. Therefore, they should speed up collections and slow down payments.
Explanation for Choice C:
If the U.S. dollar rises in value in the future, U.S. dollars will be worth more relative to
foreign currency and the foreign currency is worth less compared to the dollar.
Therefore the company will want to get as many dollars as possible now so that they will
increase in value while they are being held and the company will want to keep the
dollars that they have to use to pay the foreign denominated payables when the dollar is
stronger. Therefore, they should speed up collections and slow down payments.
405. Question ID: ICMA 19.P2.088 (Topic: International Finance)
A publicly-traded company based in Japan is planning on expanding its operations into
Germany. The expansion is estimated to cost ¥500 million, but the company needs
euros to implement the expansion. The company is not well known in Germany and
therefore hesitant to issue a euro-denominated bond in the German marketplace. If the
company were to issue a yen- denominated twenty-year bond in Japan, which one of
the following contracts should the company use?

 A. Currency swap.correct
 B. Currency forward.
 C. Currency options.
 D. Currency futures.
Question was not answered
Correct Answer Explanation:
The best strategy to use to hedge the risks of issuing debt in Yen when the needed
currency is the Euro would be to enter into a currency swap.
Explanation for Choice B:
A currency forward is not the best way to hedge the risk of issuing Yen denominated
debt when the needed currency is the Euro.
Explanation for Choice C:
A currency option is not the best way to hedge the risk of issuing Yen denominated debt
when the needed currency is the Euro.
Explanation for Choice D:
A currency future is not the best way to hedge the risk of issuing Yen denominated debt
when the needed currency is the Euro.
406. Question ID: CMA 1286 1.20 (Topic: International Finance)
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Given a spot exchange rate for the U.S. dollar against the pound sterling of 1.4925 and
a 90-day forward rate of 1.4775:

 A. The forward pound sterling is selling at a premium against the dollar in the forward
market.
 B. The pound sterling is selling at a discount against the dollar and is undervalued in the
forward market.
 C. The forward pound sterling is selling at a discount against the dollar in the forward
market.correct
 D. The pound sterling is selling at a premium against the dollar and is overvalued in the
forward market.
Question was not answered
Correct Answer Explanation:
If the spot rate is greater than the forward rate, the currency is said to be selling at a
discount in the forward market. The 1.4925 and 1.4775 are the prices of one British
pound in U.S. dollars on the spot and forward markets. Because the price of the British
pound in U.S. dollars is lower on the forward market than on the spot market, the pound
sterling is selling at a discount in the forward market.
To determine which currency has the value of 1 unit in an exchange rate quote, we
need to know the convention used in quoting exchange rates on currency exchanges.
The convention is the order in which the two currencies are listed, and the currency
listed first has the value of 1 unit. The order is:
EUR - GBP - AUD - NZD - USD - ANY OTHER CURRENCY
An exchange rate between the British pound and the U.S. dollar is quoted as GBP/USD,
with the British pound coming first. Therefore, the British pound has the value of 1 unit
in this exchange rate quote.
Explanation for Choice A:
If the spot rate is greater than the forward rate, the currency is said to be selling at a
discount, not a premium, in the forward market.
Explanation for Choice B:
If the spot rate is greater than the forward rate, the currency is said to be selling at a
discount in the forward market. However, that does not necessarily indicate anything
about the value of the currency.
Explanation for Choice D:
If the spot rate is greater than the forward rate, the currency is said to be selling at a
discount in the forward market. However, that does not necessarily indicate anything
about the value of the currency.
 Hock P2 2020
Section B - Corporate Finance.
Answers
407. Question ID: ICMA 10.P2.192 (Topic: International Finance)
Under a floating exchange rate system, which one of the following should result in a
depreciation of the British pound sterling?

 A. British interest rates rise relative to the U.S. rates.

 B. U.S. income levels improve relative to the British.
 C. Decrease in outflows of British capital to the U.S.
 D. U.S. inflation declines relative to British inflation.correct
Question was not answered
Correct Answer Explanation:
If British inflation is higher than U.S. inflation, fewer U.S. people will want to buy British
products, because they will have become comparatively more expensive than U.S.
made products. This will lead to a decreased demand for the British pound sterling on
currency markets, which will lead to a depreciation of the British pound sterling.
Explanation for Choice A:
If British interest rates rise, more people will want to purchase investments denominated
in British pounds. Therefore, the higher demand for British pounds will lead to the
appreciation of the British pound.
Explanation for Choice B:
If U.S. income levels improve relative to British income levels, people in the U.S. will be
able to buy more British imports. The increased demand for the British pound sterling
(to pay for the British imports) will cause the pound to appreciate, not depreciate.
Explanation for Choice C:
A decrease in the outflows of British capital to the U.S. will cause a lower level of supply
of British pounds. This lower supply of British pounds will cause the British pound to
appreciate.
408. Question ID: ICMA 08.P1.99 (Topic: International Finance)
Countries sometimes privatize their state-owned enterprises. U.S. firms considering
investing in these formerly state-owned enterprises must consider many factors prior to
making investments in these countries. Which one of the following is
of least importance to U.S. investors when considering the acquisition of one of these
former state-owned enterprises?

 A. Stability of the foreign currency.

 B. Transfer of technology back to the U.S.correct
 C. Restrictions on capital flows out of the foreign country.
 D. Political stability of the country.
 Hock P2 2020
Section B - Corporate Finance.
Answers
Question was not answered
Correct Answer Explanation:
The transfer of technology back to the U.S. is one of the reasons for a company to
invest in other countries. This is not a risk for the investing company.
Explanation for Choice A:
There are many risks for a company making an investment in a foreign country. One of
these is the risk of instability of the foreign currency. An unstable foreign currency may
make it difficult to do business, may create large risks for the company and is a risk of
investing in foreign countries.
Explanation for Choice C:
There are many risks for a company making an investment in a foreign country. One of
these is the risk of restrictions on capital flows out of the foreign country. This restriction
may make it difficult, expensive or even impossible to get the profits out of the country
and back to the home country.
Explanation for Choice D:
There are many risks for a company making an investment in a foreign country. One of
these is the risk of political instability. Political risks include the risk of government
seizure of private property, war, blockage of funds transfers, government regulations,
local corruption, and differences in culture.
409. Question ID: CMA 695 1.24 (Topic: International Finance)
Assuming exchange rates are allowed to fluctuate freely, which one of the following
factors would likely cause a nation's currency to appreciate on the foreign exchange
market?

 A. A slower rate of growth in income than in other countries, which causes imports to lag
behind exports.correct
 B. Domestic real interest rates that are lower than real interest rates abroad.
 C. A high rate of inflation relative to other countries.
 D. A relatively rapid rate of growth in income that stimulates imports.
Question was not answered
Correct Answer Explanation:
If imports lag behind exports there will be increased demand for the domestic currency
as foreigners need the currency to buy the exports. This causes the domestic currency
to appreciate.
Explanation for Choice B:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Lower real interest rates make domestic assets less attractive, thus causing the
demand for domestic currency to fall. This causes the domestic currency to depreciate.
Explanation for Choice C:
A higher rate of inflation raises the price of domestic goods, which decreases exports
and the demand for the domestic currency. As a result, the domestic currency
depreciates.
Explanation for Choice D:
Increasing the amount of imports increases the demand for foreign currency, which
causes a depreciation in the value of the domestic currency.
410. Question ID: ICMA 13.P2.037 (Topic: International Finance)
A U.S. company has an account payable it must pay in six months with one Japanese
company, and an account receivable to be received in six months with another
Japanese company. The U.S. company would not have transaction exposure if

 A. both the account payable and the account receivable are denominated in Japanese
Yen and the Yen account receivable is less than the Yen account payable.
 B. the account payable is denominated in dollars and the account receivable is
denominated in Yen.

 C. both the account payable and the account receivable are denominated in Japanese
Yen and the Yen account receivable is greater than the Yen account payable.
 D. both the account payable and account receivable are denominated in U.S.
dollars.correct
Question was not answered
Correct Answer Explanation:
If the U.S. company's account payable and account receivable are denominated in U.S.
dollars, the U.S. company would have no transaction exposure because the U.S.
company would not need to make any currency exchanges between U.S. dollars and
Japanese Yen.
Explanation for Choice A:
The U.S. company would have transaction exposure if both the receivable and the
payable are denominated in Yen and the payable is greater than the receivable. If the
Yen depreciates against the U.S. dollar, the U.S. company will have a net currency
exchange transaction loss. If the Yen appreciates against the U.S. dollar, the U.S.
company will have a net currency exchange transaction gain.
Example: The exchange rate between the Yen and the USD is 1 Yen = $0.0099 US.
The U.S. company has a receivable of 75,000 Yen and a payable of 100,000 Yen. The
equivalent in U.S. dollars is:
 Hock P2 2020
Section B - Corporate Finance.
Answers
Receivable 75,000 Yen × 0.0099 = $742.50 US
Payable 100,000 Yen × 0.0099 = $990.00 US.
The net of the receivable and the payable is $(247.50) US.
The Yen depreciates against the USD (1 Yen will buy fewer U.S. dollars), and now 1
Yen = $0.008 US. The U.S. company's 75,000 Yen receivable is now equal to $600.00
US, and the U.S. company's 100,000 Yen payable is now equal to $800.00 U.S. The net
of the receivable and the payable is $(200.00) US, so the U.S. company has a net
currency exchange gain of $47.50 ([$200.00] minus $[247.50]).
If instead the Yen appreciates against the USD (1 Yen will buy more U.S. dollars) and
now 1 Yen = $0.015, the U.S. company's 75,000 Yen receivable is equal to $1,125.00
US. The U.S. company's 100,000 Yen payable is now equal to $1,500.00 US. The net
of the receivable and the payable is $(375.00), and the U.S. company has a net
currency exchange loss of $127.50 ([$375.00] minus [$247.50]).
Thus, whether the U.S. company would gain or lose on the currency exchange
transactions would depend upon whether the Japanese Yen were to depreciate or
appreciate against the U.S. dollar during the holding period. But the U.S. company
would have exposure to currency exchange rate fluctuations either way.
Explanation for Choice B:
The U.S. company would have no transaction exposure on the account payable
denominated in dollars because the U.S. company would not need to make a currency
exchange between U.S. dollars and Japanese Yen to pay the payable. However, the
U.S. company would have transaction exposure on the account receivable denominated
in Yen, because when the 100,000 Yen are received, the U.S. company will need to sell
the Yen and buy U.S. dollars. If the Yen depreciates against the U.S. dollar, the U.S.
company will have a currency exchange transaction loss. If the Yen appreciates against
the U.S. dollar, the U.S. company will have a currency exchange transaction gain.
Example: The exchange rate between the Yen and the USD is 1 Yen = $0.0099 US.
The U.S. company has a receivable of 100,000 Yen. The equivalent in U.S. dollars is
100,000 Yen × 0.0099 = $990.00 US.
The Yyen depreciates against the USD (1 Yen will buy fewer U.S. dollars), and now 1
Yen = $0.008 US. The U.S. company's 100,000 Yen receivable is now equal to $800.00
US. The receivable's value in U.S. dollars has declined, and the U.S. company has a
currency exchange loss of $190.00 ($800.00 minus $990.00).
If instead the Yen appreciates against the USD (1 Yen will buy more U.S. dollars) and
now 1 Yen = $0.015, the U.S. company's 100,000 Yen receivable is equal to $1,500.00
US. The U.S. company has a currency exchange gain of $510.00 ($1,500.00 minus
$990.00).
Thus, whether the U.S. company would lose or gain on the currency exchange
transaction would depend upon whether the Japanese Yen were to depreciate or
 Hock P2 2020
Section B - Corporate Finance.
Answers
appreciate against the U.S. dollar during the holding period. But the U.S. company
would have exposure to currency exchange rate fluctuations either way.

Explanation for Choice C:

The U.S. company would have transaction exposure if both the receivable and the
payable are denominated in Yen and the receivable is greater than the payable. If the
Yen depreciates against the U.S. dollar, the U.S. company will have a net currency
exchange transaction loss. If the Yen appreciates against the U.S. dollar, the U.S.
company will have a net currency exchange rate transaction gain.
Example: The exchange rate between the Yen and the USD is 1 Yen = $0.0099 US.
The U.S. company has a receivable of 100,000 Yen and a payable of 75,000 Yen. The
equivalent in U.S. dollars is:
Receivable 100,000 Yen × 0.0099 = $990.00 US
Payable 75,000 Yen × 0.0099 = $742.50 US.
The net of the receivable and the payable is $247.50 US.
The Yen depreciates against the USD (1 Yen will buy fewer U.S. dollars), and now 1
Yen = $0.008 US. The U.S. company's 100,000 Yen receivable is now equal to $800.00
US, and the U.S. company's 75,000 Yen payable is now equal to $600.00 U.S. The net
of the receivable and the payable is $200.00 US, so the U.S. company has a net
currency exchange loss of $47.50 ($200.00 minus $247.50).
If instead the Yen appreciates against the USD (1 Yen will buy more U.S. dollars) and
now 1 Yen = $0.015, the U.S. company's 100,000 Yen receivable is equal to $1,500.00
US. The U.S. company's 75,000 Yen payable is now equal to $1,125.00 US. The net of
the receivable and the payable is $375.00, and the U.S. company has a net currency
exchange gain of $127.50 ($375.00 minus $247.50).
Thus, whether the U.S. company would lose or gain on the currency exchange
transactions would depend upon whether the Japanese Yen were to depreciate or
appreciate against the U.S. dollar during the holding period. But the U.S. company
would have exposure to currency exchange rate fluctuations either way.
411. Question ID: CMA 1285 1.34 (Topic: International Finance)
An American importer of English clothing has contracted to pay an amount fixed in
British pounds three months from now. If the importer worries that the U.S. dollar may
depreciate sharply against the British pound in the interim, it would be well advised to:

 A. Sell dollars in the forward exchange market.

 B. Buy dollars in the forward exchange market.
 C. Sell pounds in the forward exchange market.
 Hock P2 2020
Section B - Corporate Finance.
Answers
 D. Buy pounds in the forward exchange market.correct
Question was not answered
Correct Answer Explanation:
By purchasing pounds in the forward exchange market, the American importer is able to
determine now the amount of dollars that will be required to settle that invoice when it
comes due. As such, they are protected against the situation in which the dollar
depreciates against the pound. If the dollar were to depreciate and the importer had not
entered into this agreement, they would need to spend more dollars in order to settle
the invoice.
Explanation for Choice A:
This answer is somewhat correct in that the U.S. importer will need to sell dollars.
However, more than the need to sell dollars, they need to buy pounds in the forward
exchange market. Since this choice makes no mention of the purchase of pounds, it is
only half correct.
Explanation for Choice B:
Buying dollars in the futures market will not help the importer because they need to sell
their dollars to buy pounds in order to settle the invoice in the future.
Explanation for Choice C:
Selling pounds in the forward exchange market will not help the importer. If the importer
sells pounds in the forward market for delivery at a later date, the importer will have to
buy the British pounds (or a forward contract to buy the British pounds) in order to fulfill
the forward contract. This will do nothing to help the importer, and it will hurt the
importer if the U.S. dollar does depreciate against the British pound because it will cost
more to buy the British pounds in the future. Furthermore, the importer needs to have
the British pounds in 3 months to pay the British invoice.