D076 Finance Skills for Managers - Set 5 - Part 1

Correct Answer: Project A

Since Project A has a higher Net Present Value (NPV), it is expected to add more value to the firm than Project B. NPV is a key metric in decision-making because it measures the direct contribution of a project to the firm’s wealth.

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. This means that the stock’s returns are expected to experience greater fluctuations compared to the market.

Correct Answer: The company is issuing more equity

Issuing more equity increases the equity base, which reduces ROE if net income remains constant. ROA could still increase if the company is utilizing its assets more efficiently, but ROE would decline due to the dilution effect of increased equity.

Correct Answer: The company has a lenient credit policy

An average collection period of 60 days suggests that customers are given a relatively long time to pay their debts, which is indicative of a lenient credit policy. A strict credit policy would result in a shorter collection period.

Correct Answer: The company’s inventory is not easily liquidated

The quick ratio excludes inventory from current assets, so a significant difference between the current ratio and the quick ratio suggests that the company’s inventory may not be easily converted to cash, which could affect its liquidity.

Correct Answer: The project will break even

An NPV of $0 means that the project’s cash inflows and outflows are equal in present value terms, indicating that the project will neither add nor lose value for the firm.

Correct Answer: Increased default risk

High financial leverage means the company is heavily reliant on debt, which increases the fixed obligation of interest payments. This heightens the risk of default if the company cannot meet these obligations.

Correct Answer: 50%

The retention ratio is the portion of net income retained in the company and is equal to 1 minus the dividend payout ratio. In this case, with a payout ratio of 50%, the retention ratio is also 50%.

Correct Answer: The project will add value

A PI greater than 1 indicates that the project’s present value of inflows exceeds the present value of outflows, meaning the project will add value to the firm.

Correct Answer: The project has lower risk than the market

A beta less than 1 indicates that the project is less volatile and, therefore, less risky compared to the market as a whole.

Correct Answer: Increase the use of debt financing

Debt financing is generally cheaper than equity financing because interest payments are tax-deductible, which lowers the firm’s overall cost of capital.

Correct Answer: A higher beta

In the CAPM formula, a higher beta increases the required rate of return because it indicates higher risk relative to the market. A lower market risk premium or risk-free rate would decrease the required return.

Correct Answer: ROE will increase

Increasing the firm’s leverage by issuing more debt can increase ROE, provided that the firm’s return on assets exceeds the cost of debt. Leverage amplifies the returns to equity holders when used effectively.

Correct Answer: The company is heavily reliant on inventory for liquidity

A low quick ratio relative to the current ratio indicates that a large portion of the company’s current assets are tied up in inventory, which is less liquid than cash or receivables.

Correct Answer: The plowback ratio will increase

The plowback ratio measures the portion of earnings retained in the firm. By retaining more earnings and paying out less in dividends, the company increases its plowback ratio.

Correct Answer: Reject the project

A negative NPV means that the project is expected to reduce the firm’s value, and it should therefore be rejected. Projects with negative NPVs do not meet the firm’s required rate of return.

Correct Answer: The firm will rely more on debt financing

Since debt is less expensive than equity, the firm may choose to use more debt in its capital structure to lower its overall cost of capital. This increases leverage but reduces the cost of financing.

Correct Answer: The project with the higher NPV

NPV is generally considered a more reliable method for evaluating projects because it provides a direct measure of how much value the project will add to the firm. IRR can be misleading when comparing projects of different sizes.

Correct Answer: The firm may struggle to meet short-term obligations

A quick ratio below 1 indicates that the firm may not have enough liquid assets to cover its current liabilities, which could result in difficulties meeting short-term obligations.

Correct Answer: Decreased cost of goods sold (COGS)

Operating margin is calculated as operating income divided by sales. A decrease in COGS increases operating income, leading to a higher operating margin.