D076 Finance Skills for Managers - Set 4 - Part 1

Correct Answer: Debt-to-Equity Ratio

The Debt-to-Equity ratio evaluates how much a company is financing its operations with debt compared to equity. By increasing debt, the ratio will change, affecting the company's leverage. The other ratios, such as Current Ratio and Quick Ratio, focus more on short-term liquidity, and Return on Equity evaluates profitability rather than financing structure.

Correct Answer: Inventory Turnover

Inventory Turnover measures how effectively a company is managing its inventory, which is directly related to asset utilization efficiency. A high turnover suggests that the firm is quickly selling its goods, increasing efficiency. Current Ratio measures liquidity, Debt Ratio measures financial leverage, and Operating Margin measures profitability.

Correct Answer: Increased risk of bankruptcy

Increasing debt raises the company’s financial leverage, which in turn increases its fixed obligations such as interest payments. This heightens the risk of bankruptcy if the company cannot meet these obligations. Higher liquidity or dividend payments are unlikely results of issuing debt, and financial leverage would increase rather than decrease.

Correct Answer: It increases the plowback ratio

The plowback ratio (also called the retention ratio) is the portion of earnings retained in the company rather than paid out as dividends. If the dividend payout ratio decreases, the firm retains more earnings, thus increasing the plowback ratio.

Correct Answer: Percent of Sales Method

The Percent of Sales Method is commonly used to forecast additional financing needs by predicting how much of the firm’s financing requirements will change based on projected sales growth. Other methods, such as Return on Assets, are not used to project financing needs.

Correct Answer: Net Present Value (NPV)

NPV is the best method for evaluating long-term projects with unpredictable cash flows because it considers the time value of money and provides a dollar amount that the investment will add to the firm. IRR focuses on percentage returns, while Payback Period ignores the time value of money. PI is useful for ranking projects but not for uncertain cash flows.

Correct Answer: Quick Ratio

The Quick Ratio (also called the acid-test ratio) measures a company’s liquidity without including inventory, as inventory is often less liquid than other current assets. The Current Ratio includes inventory, Debt-to-Equity focuses on leverage, and ROA measures profitability.

Correct Answer: The retention ratio will increase

The retention ratio, also called the plowback ratio, represents the portion of earnings retained in the company rather than paid out as dividends. By reducing the payout ratio, the company retains more of its earnings, causing the retention ratio to increase.

Correct Answer: The stock is more volatile than the market

A beta greater than 1 indicates that the stock is more volatile than the market. A beta of 1 means the stock moves with the market, while a beta less than 1 suggests the stock is less volatile. A beta of 0 would mean the stock moves independently of the market.

Correct Answer: Reduce its dividend payout ratio

By reducing its dividend payout ratio, the firm retains more earnings, increasing its equity and reducing the need for external financing (DFN). Increasing the payout ratio or operating expenses would raise the need for financing, while increasing short-term debt would not reduce the DFN.

Correct Answer: Net Present Value (NPV)

NPV is the best method for evaluating projects, as it considers both the time value of money and the risk level of the project by using the discount rate. The Payback Period and IRR do not consider risk adequately, and PI is better suited for ranking projects but may not fully capture risk differences.

Correct Answer: Increase its equity financing

By increasing equity financing, the firm reduces its reliance on debt, lowering its debt ratio. Issuing more bonds or increasing short-term debt would raise the debt ratio, and reducing retained earnings would not directly affect the debt ratio.

Correct Answer: Discounting future cash flows at a rate higher than the project’s return

A high discount rate reduces the present value of future cash flows, which could result in a negative NPV if the project’s returns do not exceed the discount rate. A high IRR or increasing cash inflows would likely result in a positive NPV, and the payback period does not affect NPV.

Correct Answer: It will reduce leverage

Selling assets to pay off debt reduces the company’s liabilities, lowering its leverage. Increased leverage means more reliance on debt, which would not occur in this scenario. ROE may be affected by changes in the company’s capital structure, but not directly due to paying off debt.

Correct Answer: The project with the lower IRR and higher NPV

NPV is generally considered a more reliable method for decision-making, as it provides a direct measure of the value added by a project. IRR can be misleading if it does not consider the scale of the project or if cash flows are not conventional.

Correct Answer: Default risk

A high debt-to-equity ratio indicates a company is heavily reliant on debt, increasing its fixed obligations such as interest payments. If the company cannot meet these obligations, it faces default risk. Liquidity risk relates to the firm’s ability to meet short-term liabilities, while market risk and interest rate risk affect the broader market or the cost of debt but do not directly cause default.

Correct Answer: Quick Ratio

The Quick Ratio measures a company’s liquidity by evaluating its ability to meet short-term obligations without relying on inventory. The Debt Ratio measures leverage, ROA measures profitability, and the P/E ratio is used to value stocks, none of which directly assess short-term liquidity.

Correct Answer: It will decrease liquidity

An increase in inventory ties up cash in unsold goods, which decreases liquidity because these assets are not immediately convertible into cash. Although inventory is considered a current asset, it is less liquid than cash or accounts receivable. It does not directly improve profitability.

Correct Answer: The project will break even

A PI of 1 means the present value of the project’s inflows equals the present value of its outflows, indicating the project will neither add nor lose value. A PI greater than 1 adds value, while a PI less than 1 would indicate a loss in value.

Correct Answer: It will increase the plowback ratio

The plowback ratio measures the portion of net income retained by the company rather than paid out as dividends. By reinvesting earnings, the company increases its plowback ratio.