Residual income is a better measure for performance evaluation of an investment center manager than return on investment because:

a.  The problems associated with measuring the asset base are eliminated.

b.  Desirable investment decisions will not be neglected by high-return divisions.

c.  Only the gross book value of assets needs to be calculated.

d.  The arguments about the implicit cost of interest are eliminated. 

Choice "b" is correct.  Residual income measures actual dollars that an investment earns over its required return rate.  Performance evaluation on this basis will mean that desirable investment decisions will not be rejected by high-return divisions.

Choice "a" is incorrect.  The asset bas must still be measured to use the residual income approach.

Choice "c" is incorrect.  Book value or fair market value may be used for either method.

Choice "d" is incorrect.  The implicit cost of interest is an issue in either case. 

Which one of the following would increase the working capital of a firm?

a. Cash collection of accounts receivable

b.  Refining of accounts payable with a two-year note payable.

c.  Cash payment of accounts payable.

d.  Payment of a thirty-year mortgage payable with cash. 

Choice "b" is correct.  Working capital (WC) increases only if current assets are increased or current liabilities are decreased.  Exchanging accounts payable (current liability) for a two-year note payable (long-term liability) would decrease current liabilities and increase working capital.

Choice "a" is incorrect.  This would not impact WC.

Choice "c" is incorrect.  This would not have an impact on WC (decrease of both CA and CL).

Choice "d" is incorrect.  This would decrease WC. 

Which of the following transactions would increase the current ratio and decrease net profit?

a.  A federal income tax payment due from the previous year is paid.

b.  A long-term bond is retired before maturity at a discount.

c.  A stock dividend is declared.

d.  Vacant land is sold for less than the net book value. 

Choice "d" is correct.  The current ratio is current assets divided by current liabilities.  The sale of land would increase cash and therefore current assets without increasing current liabilities.  This would increase the current ratio.  Furthermore, the sale of land at a loss would decrease net profit.

Choice "a" is incorrect.  The payment of a tax payment would not decrease net profit because the expense was accrued last year.

Choice "b" is incorrect.  The use of cash to retire a long-term bond would reduce current assets without reducing current liabilities.  This would reduce the current ratio.

Choice "c" is incorrect.  As above, this would reduce cash without reducing current liabilities. 

Garo Company, a retail store, is considering foregoing sales discounts 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.  24.0 percent

b.  24.5 percent

c.  36.0 percent

d.  36.7 percent

Choice "d" is correct.  36.7% annual cost of credit if cash discount is not taken.

    360   x        2%    =36.7%

(30-10)    100%-2%

Choices "a", "b", and "c" are incorrect, per the above calculation.

A working capital technique, which delays the outflow of cash, is:

a.  Factoring

b.  A draft

c.  A lock-box system

d.  Compensating balances 

Choice "b" is correct.  A draft.

Choice "a" is incorrect.  Factoring is a sale of accounts receivable to a factor.  This has no effect on cash disbursements.

Choice "c" is incorrect.  A lock-box system is used to accelerate the inflow of funds.

Choice "d" is incorrect.  Compensating balances are a bank requirement related to a loan.  The bank will require a certain balance be maintained in cash.  This amount cannot be used for working capital purposes. 

Investors are likely to view a high price earnings (P/E) ratio as an indication that:

a.  Earnings have growth potential

b.  Earnings have peaked and will remain flat.

c.  Earnings have peaked and will likely fall.

d.  There is no logical conclusion to reach about the relationship between price and earnings. 

Choice "a" is correct.  The P/E ratio measures the amount that investors are willing to pay for each dollar of earnings per share.  Higher P/E ratios generally indicate that investors are anticipating more growth and are bidding up the price of the shares in advance of performance.

Choice "b" is incorrect.  High P/E ratios generally indicate investor confidence in earnings growth, not performance that has peaked.

Choice "c" is incorrect.  High P/E ratios generally indicate investor confidence in earnings growth, not that performance will fall.

Choice "d" is incorrect.  High P/E ratios give some insight into investor confidence of earnings growth.

An analyst notes the current price of Karnani Enterprises stock is $15 per share while the EPS is $3.  If the PEG ratio is 1.25, what has the analyst projected as the growth rate for Karnani Enterprises?

a.  25%

b.  20%

c.  5%

d.  4% 

Choice "d" is correct.  The PEG ratio is the ratio of the P/E ratio to the anticipated growth rate.  In this case, we would express the PEG ratio as follows:

PEG=(P0 / E0)/ (G x 100)

1.25 = ($15/3)/ (G x 100)

1.25=5/(Gx100)

Gx125=5

G=5/125

G=4%

Choice "a" is incorrect.  The analyst's growth rate is not the PEG-1.

Choice "b" is incorrect.  The analyst's growth rate is not the earnings/ price ratio (3/15).

Choice "c" is incorrect.  The analyst's growth rate is not the P/E ratio divided by 100.