اسئلة وتمارين

Know the difference between the levels of service

Audite high , Compilation low

Know why privately held companies have to file 10K’s? with the SEC

support bank lending

What is a financial Statement Review?

substantially less in scope , negative assurance

Know the levels of service for which CPA does not need to be independent 

Compilation,

What should a CPA do if he or she finds incorrect or incomplete information?

the accountant should obtain additional or revised information.

Certain procedures are associated with levels of service

Compilation Procedures

Understanding of the accounting principles and practices in the client’s

n Business transactions

n Accounting records

n Accounting personnel qualifications

n Financial statement accounting basis, and

n Financial statement form and content

n Read the compiled statements and consider whether they appear to be appropriate and free from obvious material errors.

Review Procedures

Understanding of the accounting principles and practices in the client’s

analytical procedures , no material modifications need to be made

The Audit Procedures

Audit Planning

Tests of Controls

Substantive Tests: Analytical Procedures, Tests of Details

Compilations don’t include substantive tests

Accountant is not required to make inquiries or perform other procedures to verify, corroborate, or review the information supplied by the client

The concept of performing a financial statement review appears over and over in the exam   ç انتبه لهذا

 There are certain levels of service where you can rely on management assertions

 Other levels of service where you cannot ,?Know the difference?

Compilation you rely

Audit, review you don't rely.

Because there is an opinion in the audit and review

Know all types of risk :

n Inherent risk – the risk of material noncompliance assuming no internal control

n Control risk – risk material noncompliance could occur and not be prevented or detected on a timely basis by internal control

n Detection risk – practitioner’s procedures lead to conclusion that material noncompliance does not exist when it does

n Audit – risk that the opinion will be wrong

Objective of test control?

Control – if control risk is  low you assume controls work, if control risk is high, you

assume controls do not work

you have to know:

n  The tests ordinarily include evidence obtained through

n Inquiry of personnel

n Inspection of documents and reports

n Observation of the application of the control

n Reperformance of the control

Analytical procedures are associated with reviews

n Developing expectations by identifying plausible relationships that are expected to exist based on the accountant’s understanding of entity and industry

n Comparing recorded amounts, or ratios, to expectations

n Expectations developed for a review are ordinarily less encompassing that those for an audit

n In a review, the accountant is ordinarily not required to corroborate management’s responses, although the accountant should consider those responses for reasonableness and consistency with other information.

Government auditing standards require tests of controls

Question 11

If control risk is established at high, it is likely the auditor will _increase testing and assume that the control is weak____

Question 12

The objective of tests of internal controls is ___ to evaluate whether internal control operated effectively _____________________

What is auditors reliance on?  

Substantive test:

Auditor’s reliance on substantive tests to achieve an audit objective may be derived from

n Analytical procedures

n Test of details of transactions and balances

n A combination of analytical procedures and tests of details of transactions

Intended to achieve ?  

n  Used to substantiate account balances

n  Restrict detection risk – the risk that audit procedures will incorrectly lead to a conclusion that a material misstatement does not exist in an account balance when in fact such a misstatement does exist

n  Provide evidence as to whether actual account balances are proper

Which of the following is a common pressure on auditors?

n Pressure to retain clients while remaining objective and serving the public interest

n Fee pressure – how much assurance can you really provide?

n  Cannot test an unlimited number of transactions

n  Budget/Testing tradeoff

n Realization pressure imposed by the accounting firm

n The expectation that if there is fraud, a routine audit will find it

n Will you successfully identify the high risk areas so that you can focus your testing

n “Sanitized test samples” once they have been disclosed

n Your client will know his industry much better than you do

n Time pressure to complete the engagement – the next engagement has already been scheduled

n  What is conservative for financial reporting (e.g. understated revenue) is aggressive for tax reporting purposes.  Client will be monitoring this tradeoff.

n  How does the company keep the bank happy while paying minimal taxes?

n  What motivates management?

Some entities try to appear “poorer” than they really are. They are ?

 I suspect non-profits is the answer????????????

n  Not-for-profits seeking donors

n  Unrestricted versus restricted net assets, etc

If you can post to A/R, you should not be able to do

1 )

2)

3)

Why did ENRON use SPEs?

To take advantage from the 3% rule to omit SPE's assets and liability from its consolidated financial statement, and to get the 97% from outside loaners  

What questionable revenue recognition procedure practice did ENRON use?

What factors most affected Arthur Anderson in how they handled the ENRON audit?

21) What are the three components of the fraud triangle ?

• Rationalization

• Perceived motivation

• Perceived opportunity

22)What are the three incompatible functions?  ( appeared earlier in exam )

17) Incompatible Functions

n incompatible functions…

n Custody of assets

n Ability to post to the accounting system

n Ability to authorize transactions

23)Recall which category of fraud accounted for 90% of the ACFE? Report

Asset misappropriation (91.5%)     

24)How are most frauds detected?

Tips = 34.2%

25) What does SAS 99 establish?

Establishes standards and provides guidance to auditors in fulfilling that responsibility, as it relates to fraud, in an audit of financial statements conducted in accordance with generally accepted auditing standards (GAAS)

What is primary factor that establishes fraud from error?

n  The primary factor that distinguishes fraud from error is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional.

27) What is auditor’s primary responsibility under SAS 99?

n  The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. الأجابه C 

28) Does SAS 99 require auditor to find fraud?

n  The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by fraud or error.

n  Absolute assurance is not attainable.

n  Even a properly planned and performed audit may not detect a material misstatement resulting from fraud.

n  A material misstatement may not be detected because of the nature of audit evidence or because the characteristics of fraud may cause the auditor to rely unknowingly on audit evidence that appears to be valid, but is, in fact, false and fraudulent.

n  Audit procedures that are effective for detecting an error may be ineffective for detecting fraud.

Question 28

SAS requires the auditor to

-          make inquiries of management

-          adapt a particular presumption

-          presume ___overstate___ of revenue  

SAS 99 recommends?

29/ what the particular  presumption?

Overstate of revenue

30 what if the auditor can not conclude?

withdrawal from the engagement with communication to the appropriate parties may be an appropriate course of action

Know the inventory fraud in the HEALTH MANAGEMENT case

How did the inventory fraud affect the financial statements?

Why does that __________________  type of inventory

Why did early release of  financial statements create ___________________

Define recklessness

Gross negligence

Waived  and passed or past adjustments. How do they affect audits?

n  As issues are noted during the audit, adjustments may become necessary

n  Must determine if the adjustments will be “booked” or “waived.”

n  The effect of cumulative waived adjustments must be assessed from year to year.

n  When does making (proposing) audit adjustments become managing the company??  There is no bright line test but the auditor must always consider.

n  Some company’s or controllers resist making audit adjustments at all costs.  For some, it is interpreted as if they have made errors.

35) There is a fill in that asks you to name four of the eight things auditors are not allowed to do for public companies in contractual audit relation.

Bookkeeping ,financial information design, internal audit outsourcing services, broker  or dealer   

36)Know the significant changes imposed by SAS 105

SAS 105 – Amendment to Statement on Auditing Standards No. 95, Generally Accepted Auditing Standards

n  Expands the scope of the second standard of field work from “internal control” to the “entity and its environment, including its internal control.”

n  Extends the purpose from “planning the audit” to “assessing the risk of material misstatement of the financial statements whether due to error or fraud.”

n  The phrase “tests to be performed” is replaced with “further audit procedures” in recognition that audit procedures are also performed to obtain the understanding on which the auditor’s risk assessments are based.

SAS 105

n  Revised the third standard of field work to eliminate references to specific audit procedures which imply that those identified encompass all audit procedures, and to replace the terminology “evidential matter” with “audit evidence.”

n  Revised the auditing standards to clarify the terminology used in SASs issued by the Auditing Standards Board in describing the professional requirements imposed on auditors.

37) There is a fill in that asks you to identify 2 things the auditor should identify. Relating to SAS 106?

n Defines audit evidence

n Defines relevant assertions and discusses their use in assessing risks and designing appropriate further audit procedures

Question 38

Under the audit risk model as audit risk increases there are certain things auditor need to do

n  The auditor must communicate all known and likely misstatements identified during the audit, other than those that the auditor believes are trivial, and communicate them to the appropriate level of management.

n  The auditor must evaluate whether the financial statements taken as a whole are free of material misstatement based upon all the information obtained at audit including consideration of known and likely misstatements, discussion with management, etc.

n  The auditor must evaluate the overall effect of audit findings on the auditor’s report.

If _____________ risk is high it means that the underlying stuff is not reliable

Control risk means everything is screwed up

Detection risk means that your audit program does not work

Under SAS 106 how does quality relate to quantity for audit evidence?

n Sufficiency is the measure of the quantity of audit evidence

n Appropriateness is the measure of the quality of audit evidence that is, its relevance and its reliability in providing support for, or detecting misstatements in, the classes of transactions, account balances, and disclosures and related assertions.

n Greater risk = more audit evidence needed

n Higher quality evidence = less evidence needed

40)SAS 106 identifies four assertions ( this is a fill in question) that pertain to account balances at period end. Provide 2 of the 4

n Existence

n Rights and obligations

n Completeness

n Valuation and allocation

41)SAS 106 requires the auditor to test controls under either of two circumstances. Choose the two

n When the auditor’s risk assessment includes an expectation of the operating effectiveness of controls, the auditor should test those controls to support the risk assessment

n When the substantive procedures alone do not provide sufficient appropriate audit evidence, the auditor should perform test of controls to obtain audit evidence about their operating effectiveness

42)In accordance with GAGAS, who rules?

  GAGAS

Under SAS 107 there are two types of misstatements. Four are supplied, choose the correct 2 out of the four. This may relate to known or likely misstatements

n Known misstatements are those identified during the audit

n Likely misstatements are those that

n arise from differences between management’s and the auditor’s judgments concerning accounting estimates that the auditor considers unreasonable or inappropriate.

n Are likely to exist based on an extrapolation from audit evidence obtained (for example, the amount obtained by projecting known misstatements identified in an audit sample to the entire population from which the sample was drawn).

Most important factor ___________________?

Under SAS 107 know the three kinds of risk. This is a fill in

Control

Detection

Inherent

44) According to SAS 107   Inherent risk  No related controls??????????

Control risk misstatement will not be prevented … Control . Internal control???????????

Detection risk – the auditor will not detect

47)Under 107 …. Tolerable misstatement …The maximum error in a population ??????

48) Know the difference between the preliminary estimate of materiality and a tolerable misstatement

SAS 112 changed previous terminology

n The nature of the accounts, disclosures and assertions involved (suspense accounts and related party transactions = greater risks)

n Susceptibility of the related assets or liabilities to loss or fraud

n The subjectivity and complexity of the amount involved, and the extent of judgment needed to determine that amount

n Cause and frequency of any known or detected exceptions related to the operating effectiveness of a control

n Interaction or relationship of the control with other controls

n Interaction of the control deficiency with other control deficiencies

n Possible future consequences of the deficiency

49) A Control deficiency exists when design or operation does not allow ….prevent ………..timely basis

Significant deficiency

Control deficiency

Material weakness

n  Control deficiency

n Exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis

n  Significant deficiency

n Is a control deficiency, or combination of control deficiencies, that adversely affects the entity’s ability to initiate, authorize, record, process, or report financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the entity’s financial statements that is more than inconsequential will not be prevented or detected.

n

Material weakness

n Is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected

50) Under SAS 112 significance of a control deficiency depends on_______________

n  the potential for a misstatement, not on whether a misstatement actually has occurred.

Yes or no? question

51) Under SAS 112   absence of identified misstatement

No,

When can you make distinction between significant deficiency and a material weakness?

GAGAS are usually far more rigorous than GAAS

Yes

Testing areas of compliance are a distinguishing feature of GAGAS v. AICPA standards

n  The American Institute of Certified Public Accountants (AICPA) has established professional standards that apply to financial audits and attestation engagements for nonissuers performed by certified public accountants (CPA). (“Nonissuer” refers to any entity other than an issuer under the Sarbanes-Oxley Act of 2002, such as privately held companies, nonprofit entities, and government entities.)

n  For financial audits, GAGAS incorporate the AICPA field work and reporting standards and the related Statements on Auditing Standards (SAS) unless specifically excluded or modified by GAGAS.

n  For attestation engagements, GAGAS incorporate the AICPA general standard on criteria, and the field work and reporting standards and the related Statements on Standards for Attestation Engagements (SSAE) unless specifically excluded or modified by GAGAS.

n  GAGAS describe ethical principles, and establish independence and other general standards, and additional field work and reporting standards beyond those provided by the AICPA for performing financial audits and attestation engagements.

54)Distinguishing feature between GAAS and GAGAS is reporting standards.

n  Reporting

n  Adherence to GAAP

n  Consistent application

n  Adequate disclosure

n  Expression of opinion

n  Reporting

n  Adherence to GAAP

n  Consistent application

n  Adequate disclosure

n  Expression of opinion

n  Report distribution not restricted

n  In accordance with GAAS and GAGAS

n  Report on Compliance and Internal Control

GAGAS has a whole different set of reports and opinions

n Reporting on financial audits performed in accordance with GAGAS includes 1-reports on internal control,2- compliance with laws and regulations, 3-and provisions of contracts 4-and grant agreements as they relate to financial transactions,5- systems, and processes.

n فراغ  GAGAS audits produce Findings that may include___ Audit findings may involve deficiencies in internal control, fraud, illegal acts, violations of provisions of contracts or grant agreements, and abuse. The elements needed for a finding depend entirely on the objectives of the audit.

___________________________________________________________

There is a true and false  involving considering using lower materiality levels

TRUE.

Requirement THAT Distinguishing Circular A 133

l Circular A-133 require the use of Government Auditing Standards.

Schedule of awards

l The expenditure of a federal award is very broadly defined

l The outstanding federal loan balances may be considered an expenditure of the outstanding balance every year.

l Accepting title to a retired federal building with a fair value of $500,000 or greater could trigger an audit.

62) How much federal money is the threshold? 

 500000

63-What the different between Standard 133 and Government?

n Financial statements

n Schedule of expenditures of federal awards (SEFA)

n All applicable footnotes to both F/S and SEFA

n Auditor’s reports

n Schedule of findings and questioned costs

n Summary Schedule of Prior Audit Findings (if applicable)

n Corrective Action Plan (if applicable)

n Data Collection Form

64) What is the significant contribution of the TREADWAY Commission?

   COSO?

l The COSO (Committee of Sponsoring Organizations of the Treadway Commission) Study defined internal control as:

n “A process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories:

l Effectiveness and efficiency of operations

l Reliability of financial reporting

l Compliance with applicable laws and regulations”

Auditing SEFA is the point of A 133 audits

l 59)SEFA (Schedule of Expenditure of Federal Awards)

l Compliance audit of federal awards

What is defined as an expenditure of a federal award?

l The expenditure of a federal award is very broadly defined

l The outstanding federal loan balances may be considered an expenditure of the outstanding balance every year.

l Accepting title to a retired federal building with a fair value of $500,000 or greater could trigger an audit.

Know what a single audit is

l The term “single audit” is misleading since the auditor is actually conducting two audits; one on the fair presentation of the financial statements, and the other on compliance with major federal programs

Who is subject to the single audit act?

l Non federal entities

l Other entities such as State and local governmental units

l Not-for-profit entities that meet the criteria

Yellow book = GAGAS

65)

E

A 133 has a table of things that auditors test, you should know the list, which includes eligibility, allowable cost, etc.

l Activities Allowed or Unallowed

l Allowable Costs/Cost Principles

l Cash Management

l Davis Bacon Act

l Eligibility

l Equipment and Real Property Management

l Matching, level of effort, earmarking

l Period of Availability

l Procurement, Suspension, and Debarment

l Program Income

l Real Property Acquisition and Relocation Assistance

l Reporting

l Subrecipient Monitoring

l Special Tests and Provisions

Question 65 is A133 “all of the above”, which is the list from the question above

E

In the CASE studies

The primary motivation for overstating inventory is

Yes – opportunities to __________

Yes – overstate book income

No – overstate tax liability

Inventory overstatements impact ____ overstate book income __

An entity that engages in exceedingly difficult _______________

Form over substance, substance over form

Why would people move stuff in balance sheet?

Ratios and debt covenants

Management assertion

-          existence

-          value

-          there is a whole list of things

72)Largest amount of …  uncorrected misstatement … ….. would appear based upon ………… preliminary estimate of materiality  …… and……… tolerable misstatement  

Certain components making up an account balance will be deemed to be “individually significant” based upon preliminary estimate of materiality and tolerable misstatement

Items contained within an account of interest

Individual conformations

Test 100% of individually significant accounts

(For big sample number)The individually significant items will generally all be tested Sample smaller accounts

.(small number)The non-individually significant items may be sampled as part of the substantive testing plan.

Random sampling techniques

Tax staff expectations on audit team. Know what the built in conflict is

n  The audit team must recognize that financial statement materiality may cause items of tax significance to fall below the radar.  The team must be astute enough to recognize that certain tax adjustments must be sought throughout fieldwork as one is working within the accounts because they must ultimately be found, e.g.

n Accrued expenses to related party cash basis taxpayers

n Accrued salaries not paid within the required intervals after year end

n Cash value of life insurance adjustments

n Allowance for bad debts versus actual write offs

n Political contributions

n Disallowed meals and entertainment expenses

Communications from management , know different kinds of letters that go back and forth

engagement letter

Obtain the legal disclosure letter

Obtain the management representation letter

What will happen if Federal auditors discover a large difference after the fiscal year has ended?

Know what low balling means and why it is a bad idea

تعويض أجر المراجعة من الاستشارات

Know types of risk really well

11 fill ins. Three relate to SAS 112 and three relate to types of risk

1.         Which of the following statements is most correct?

a.   One of the ways in which firms can mitigate or reduce agency problems between bondholders and stockholders is by increasing the amount of debt in the capital structure.

b.   The threat of takeover is one way in which the agency problem between stockholders and managers can be alleviated.

c.   Managerial compensation can be structured to reduce agency problems between stockholders and managers.

d.   Statements b and c are correct.

e.   All of the statements above are correct

Firm organization                                        Answer: a  Diff: E  N

2.    Until this year, Cheers Inc. was organized as a partnership.  This year, the partners have decided to organize the business as a corporation.  As a result of this change in organizational form, which of the following statements is most correct?

a. Cheers’ shareholders (the ex-partners) will now have limited liability.

b. Cheers will now be subject to fewer regulations.

c. Cheers will now pay less in taxes.

d. Cheers’ investors will now find it more difficult to transfer ownership.

e. Cheers will now find it more difficult to raise additional capital.

Net cash flow, free cash flow, and cash                                                Answer: c  Diff: E  N

3.         Last year, Owen Technologies reported negative net cash flow and negative free cash flow.  However, its cash on the balance sheet increased.  Which of the following could explain these changes in its cash position?

a.   The company had a sharp increase in its depreciation and amortization expenses.

b.   The company had a sharp increase in its inventories.

c.   The company issued new common stock.

d.   Statements a and b are correct.

e.   Statements a and c are correct.

Income statement                                         Answer: b  Diff: E  N

4.        Cox Corporation recently reported an EBITDA of $22.5 million and $5.4 million of net income.  The company has $6 million interest expense and the corporate tax rate is 35 percent.  What was the company’s depreciation and amortization expense?

a. $ 4,333,650

b. $ 8,192,308

c. $ 9,427,973

d. $11,567,981

e. $14,307,692

Financial statement analysis                                                                              Answer: e  Diff: E

5.    Company A and Company B have the same total assets, return on assets (ROA), and profit margin. However, Company A has a higher debt ratio and interest expense than Company B.  Which of the following statements is most correct?

a. Company A has a higher ROE (return on equity) than Company B.

b. Company A has a higher total assets turnover than Company B.

c. Company A has a higher operating income (EBIT) than Company B.

d. Statements a and b are correct.

e. Statements a and c are correct.

Du Pont equation                                                                                               Answer: a  Diff: E

6.         The Wilson Corporation has the following relationships:

Sales/Total assets                                2.0´

Return on assets (ROA)                      4.0%

Return on equity (ROE)                     6.0%

What is Wilson’s profit margin and debt ratio?

a.   2%; 0.33

b.   4%; 0.33

c.   4%; 0.67

d.   2%; 0.67

e.   4%; 0.50

Liquidity ratios                                                                                                 Answer: a  Diff: M

7.         Oliver Incorporated has a current ratio equal to 1.6 and a quick ratio equal to 1.2.  The company has $2 million in sales and its current liabilities are $1 million.  What is the company’s inventory turnover ratio?

a.   5.0

b.   5.2

c.   5.5

d.   6.0

e.   6.3

CAPM                                                                                                           Answer: b  Diff: E  N

8.         The risk-free rate is 6 percent.  Stock A has a beta of 1.0, while Stock B has a beta of 2.0.  The market risk premium (k_M – k_RF) is positive. Which of the following statements is most correct?

a.   Stock B’s required rate of return is twice that of Stock A.

b.   If Stock A’s required return is 11 percent, the market risk premium is 5 percent.

c.   If the risk-free rate increases (but the market risk premium stays unchanged), Stock B’s required return will increase by more than Stock A’s.

d.   Statements b and c are correct.

e.   All of the statements above are correct.

CAPM and required return                                    Answer: a  Diff: M

9.    Bradley Hotels has a beta of 1.3, while Douglas Farms has a beta of 0.7. The market return is 12 percent.  The risk-free rate of interest is 7 percent.  By how much does Bradley’s required return exceed Douglas’ required return?

a. 3.0%

b. 6.5%

c. 5.0%

d. 6.0%

e. 7.0%

Portfolio return                                                                                                  Answer: a  Diff: E

10.       An investor is forming a portfolio by investing $50,000 in stock A that has a beta of 1.50, and $25,000 in stock B that has a beta of 0.90. The return on the market is equal to 6 percent and Treasury bonds have a yield of 4 percent. What is the required rate of return on the investor’s portfolio?

a.    6.6%

b.    6.8%

c.    5.8%

d.    7.0%

e.    7.5%

Portfolio beta                                                                                                     Answer: e  Diff: M

11.       Walter Jasper currently manages a $500,000 portfolio.  He is expecting to receive an additional $250,000 from a new client.  The existing portfolio has a required return of 10.75 percent.  The risk-free rate is 4 percent and the return on the market is 9 percent.  If Walter wants the required return on the new portfolio to be 11.5 percent, what should be the average beta for the new stocks added to the portfolio?

a.    1.50

b.    2.00

c.    1.67

d.    1.35

e.    1.80

Required return          Answer: c  Diff: M

12.       You are holding a stock that has a beta of 2.0 and is currently in equilibrium.  The required return on the stock is 15 percent, and the market return is 10 percent.  What would be the percentage change in the return on the stock, if the market return increased by 30 percent while the risk-free rate remained unchanged?

a.    +20%

b.    +30%

c.    +40%

d.    +50%

e.    +60%

Beta coefficient                                                                                                  Answer: b  Diff: E

13.       Given the following information, determine which beta coefficient for Stock A is consistent with equilibrium:

 = 11.3%; k_RF = 5%; k_M = 10%

a.    0.86

b.    1.26

c.    1.10

d.    0.80

e.    1.35

Effective annual rate                                                            Answer: d  Diff: E

14.       Which of the following statements is most correct?

a.   If annual compounding is used, the effective annual rate equals the nominal rate.

b.   If annual compounding is used, the effective annual rate equals the periodic rate.

c.   If a loan has a 12 percent nominal rate with semiannual compounding, its effective annual rate is equal to 11.66 percent.

d. Statements a and b are correct.

e.   Statements a and c are correct.

PV of an uneven CF stream                                                                             Answer: b  Diff: E

15.       A real estate investment has the following expected cash flows:

                                                Year                      Cash Flows

                                                    1                            $10,000

                                                    2                              25,000

                                                    3                              50,000

                                                    4                              35,000

The discount rate is 8 percent. What is the investment’s present value?

a.   $103,799

b.   $ 96,110

c.   $ 95,353

d.   $120,000

e.   $ 77,592

Time value of money and retirement                                                          Answer: b  Diff: E  N

16.   Today, Bruce and Brenda each have $150,000 in an investment account.  No other contributions will be made to their investment accounts.  Both have the same goal:  They each want their account to reach $1 million, at which time each will retire.  Bruce has his money invested in risk-free securities with an expected annual return of 5 percent.  Brenda has her money invested in a stock fund with an expected annual return of
10 percent.  How many years after Brenda retires will Bruce retire?

a.   12.6

b.   19.0

c.   19.9

d. 29.4

e.   38.9

Answer a

17.   A bank recently loaned you $15,000 to buy a car.  The loan is for five years (60 months) and is fully amortized.  The nominal rate on the loan is 12 percent, and payments are made at the end of each month.  What will be the remaining balance on the loan after you make the 30th payment?

a.   $ 8,611.17

b.   $ 8,363.62

c.   $14,515.50

d.   $ 8,637.38

e.   $ 7,599.03

Required annuity payments

The following information is needed to answer the next two questions

            Karen and her twin sister, Kathy, are celebrating their 30th birthday today.  Karen has been saving for her retirement ever since their 25th birthday.  On their 25th birthday, she made a $5,000 contribution to her retirement account.  Every year thereafter on their birthday, she has added another $5,000 to the account.  Her plan is to continue contributing $5,000 every year on their birthday.  Her 41st, and final, $5,000 contribution will occur on their 65th birthday.

            So far, Kathy has not saved anything for her retirement but she wants to begin today.  Kathy’s plan is to also contribute a fixed amount every year.  Her first contribution will occur today, and her 36th, and final, contribution will occur on their 65th birthday.  Assume that both investment accounts earn an annual return of 10 percent. 

                                                                                                                                            Answer c

18        Determine how much Karen will have saved by age 65.

1. $1,980,661.
2. $1,980,666.
3. $2,439,259.
4. $1,231,664.
5. $1,015,330.

                                                                                                                      Answer: b  Diff: M  N

19        How large does Kathy’s annual contribution have to be for her to have the same amount in her account at age 65, as Karen will have in her account at age 65?

a.   $9,000.00

b.   $8,154.60

c.   $7,398.08

d.   $8,567.20

e.   $7,933.83

Bond concepts                                                                                                    Answer: a  Diff: E

20.       Which of the following statements is most correct?

a.   All else equal, if a bond’s yield to maturity increases, its price will fall.

b.   All else equal, if a bond’s yield to maturity increases, its current yield will fall.

c.   If a bond’s yield to maturity exceeds the coupon rate, the bond will sell at a premium over par.

d.   All of the statements above are correct.

e.   None of the statements above is correct.

Bond value--semiannual payment                                                                    Answer: b  Diff: E

21.       A bond with a $1,000 face value and an 8 percent annual coupon pays interest semiannually.  The bond will mature in 15 years.  The nominal yield to maturity (K_d) is 11 percent.  What is the price of the bond today?

a.   $  784.27

b.   $  781.99

c.   $1,259.38

d.   $1,000.00

e.   $  739.19

YTM and YTC--semiannual bond                                                                   Answer: e  Diff: E

22.   A corporate bond matures in 14 years.  The bond has an 8 percent semiannual coupon and a par value of $1,000.  The bond is callable in five years at a call price of $1,050.  The price of the bond today is $1,075.  What are the bond’s yield to maturity and yield to call?

a. YTM = 14.29%; YTC = 14.09%

b. YTM =  3.57%; YTC =  3.52%

c. YTM =  7.14%; YTC =  7.34%

d. YTM =  6.64%; YTC =  4.78%

e. YTM =  7.14%; YTC =  7.05%

Bond value--semiannual payment                                                                    Answer: d  Diff: E

23.       Assume that you wish to purchase a 20-year bond that has a maturity value of $1,000 and makes semiannual interest payments of $40.  If you require a 10 percent nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond?

a.   $619

b.   $674

c.   $761

d.   $828

e.          $902

Current yield and yield to maturity                                                                 Answer: b  Diff: E

24.       A bond matures in 12 years and pays an 8 percent annual coupon.  The bond has a face value of $1,000 and currently sells for $985.  What is the bond’s current yield and yield to maturity?

a.   Current yield = 8.00%; yield to maturity = 7.92%

b.   Current yield = 8.12%; yield to maturity = 8.20%

c.   Current yield = 8.20%; yield to maturity = 8.37%

d.   Current yield = 8.12%; yield to maturity = 8.37%

e.   Current yield = 8.12%; yield to maturity = 7.92%

Bond coupon rate                                                                                             Answer: c  Diff: M

25.       Cold Boxes Ltd. has 100 bonds outstanding (maturity value = $1,000).  The nominal required rate of return on these bonds is currently 10 percent (K_d), and interest is paid semiannually.  The bonds mature in 5 years, and their current market value is $768 per bond.  What is the annual coupon interest rate?

a.   8%

b.   6%

c.   4%

d.   2%

e.   0%

ANSWERS

[1].    Agency                                                Answer: d  Diff: M

Statement d is most correct. Statement a is incorrect, because increasing the amount of debt can increase agency problems.

2.    Firm organization                                  Answer: a  Diff: E  N

Except for statement a, all the other statements are exactly opposite for corporations.

3.    Net cash flow, free cash flow, and cash   Answer: c  Diff: E  N

The correct answer is statement c.  Recall Net cash flow = NI + DEP and AMORT.  Free cash flow = EBIT(1 - T) + Depreciation and amortization – Capital expenditures – ΔNOWC.

An increase in depreciation and amortization expenses increases both NCF and FCF, and may reduce taxes.  This does not explain why NCF and FCF are negative with an increase in cash flow.  So, statement a is not correct. An increase in inventories is paid either in cash or accounts payable.  This suggests cash either decreases or remains the same.  So, statement b is incorrect.  By issuing new stock, cash does increase.  And this has no impact on either NCF or FCF, so statement c is the correct response.

4.    Income statement                                   Answer: b  Diff: E  N

5.    Financial statement analysis                          Answer: e  Diff: E

From the first sentence, both firms have the same net income, sales, and assets.  Since A has more debt, it must have less equity.  Thus, its ROE (calculated as Net income/Equity) is higher than B’s.  So statement a is correct.  Since the two firms have the same total assets and sales, their total assets turnover ratios must be the same.  So statement b is false. If A has higher interest expense than B but the same net income, this means that A must have higher operating income (EBIT) than B. Therefore statement c is correct.  Since statements a and c are correct, the correct choice is statement e.

6.    Du Pont equation                                      Answer: a  Diff: E

First, calculate the profit margin, which equals NI/Sales:

ROA = NI/TA = 0.04.

Sales/Total assets = S/TA = 2.

PM = (NI/TA)(TA/S) = 0.04(0.5) = 0.02.  [TA/S = 1/2 = 0.5.]

Next, find the debt ratio by finding the equity ratio:

E/TA = (E/NI)(NI/TA).  [ROE = NI/E and ROA = NI/TA.]

E/TA = (1/ROE)(ROA) = (1/0.06)(0.04) = 0.667, or 66.7% equity.

Therefore, D/TA must be 0.333 = 33.3%.

7.    Liquidity ratios                                      Answer: a  Diff: M

    QR = (Current assets - Inventory)/Current liabilities

   1.2 = (CA - I)/$1,000,000

CA - I = $1,200,000.

        CR = (Current assets - Inventory + Inventory)/Current liabilities

       1.6 = ($1,200,000 + Inventory)/$1,000,000

$1,600,000 = $1,200,000 + Inventory

 Inventory = $400,000.

Inventory turnover = Sales/Inventory

                   = $2,000,000/$400,000

                   = 5.0´.

8.         CAPM                                                                                               Answer: b  Diff: E  N

The CAPM is written as:  k_s = k_RF + (k_M – k_RF)b.  Statement a is false based on the CAPM equation.  Statement b is correct on the basis of the CAPM equation.  Statement c is false; the required returns will increase by the same amount.

9.         CAPM and required return                                                              Answer: a  Diff: M

An index fund will have a beta of 1.0.  If k_M is 12 percent (given in the problem) and the risk-free rate is 7 percent, you can calculate the market risk premium (RP_M).

 k_s    = k_RF + (RP_M)b

12%     = 7% + (RP_M)1.0

 5% = RP_M.

Now, you can use the RP_M, the k_RF, and the two stock’s betas to calculate their required returns.

Bradley:

k_s  = k_RF + (RP_M)b

     = 7% + (5%)1.3

     = 7% + 6.5%

     = 13.5%.

Douglas:

k_s  = k_RF + (RP_M)b

     = 7% + (5%)0.7

     = 7% + 3.5%

     = 10.5%.

The difference in their required returns is:

13.5% - 10.5% = 3.0%.

10.   Portfolio return                                      Answer: a  Diff: E

The portfolio’s beta is a weighted average of the individual security betas as follows:

($50,000/$75,000)1.5 + ($25,000/$75,000)0.9 = 1.3.  The required rate of return is then simply:  4% + (6% - 4%)1.3 = 6.6%.

[1]1.   Portfolio beta                                        Answer: e  Diff: M

Find the beta of the original portfolio (b_Old) as 10.75% = 4% + (9% - 4%)b_Old or b_Old = 1.35.  To achieve an expected return of 11.5%, the new portfolio must have a beta (b_New) of 11.5% = 4% + (9% - 4%) or  = 1.5.  To construct a portfolio with a b_New = 1.5, the added stocks must have an average beta (b_Avg) such that:

1.5 = ($250,000/$750,000)b_Avg + ($500,000/$750,000)1.35

1.5 = 0.333b_Avg + 0.90

0.6 = 0.333b_Avg

b_Avg = 1.8.

[1]2.   Required return                                       Answer: c  Diff: M

Step 1:  Solve for risk-free rate

         15% = k_RF + (10% - k_RF)2.0

         15% = k_RF + 20% - 2k_RF

          k_RF = 5%.

Step 2: Calculate new market return

        k_M increases by 30%, so k_M = 1.3(10%) = 13%.

Step 3: Calculate new required return on stock

        k_s = 5% + (13% - 5%)2 = 21%.

Step 4: Calculate percentage change in return on stock

         = 40%.

[1]3.   Beta coefficient                                      Answer: b  Diff: E

In equilibrium

k_A =  = 11.3%.

     k_A = k_RF + (k_M - k_RF)b

  11.3% = 5% + (10% - 5%)b

     b = 1.26.

[1]4.   Effective annual rate                                 Answer: d  Diff: E

Statement d is correct.  The equation for EAR is as follows:

EAR = .

If annual compounding is used, m = 1 and the equation above reduces to EAR = k_Nom.  The equation for the periodic rate is:

.

If annual compounding is used then m = 1 and k_PER = k_Nom, and since EAR = k_Nom then k_PER = EAR.

[1]5.       PV of an uneven CF stream                                                                 Answer: b  Diff: E

NPV = $10,000/1.08 + $25,000/(1.08)² + $50,000/(1.08)³ + $35,000/(1.08)⁴

    = $9,259.26 + $21,433.47 + $39,691.61 + $25,726.04

    = $96,110.38 » $96,110.

Financial calculator solution:

Using cash flows

Inputs:  CF₀ = 0; CF₁ = 10000; CF₂ = 25000; CF₃ = 50000; CF₄ = 35000; I = 8.

Output:  NPV = $96,110.39 » $96,110.

[1]6.       Time value of money and retirement                                              Answer: b  Diff: E  N

Step 1:       Find the number of years it will take for each $150,000 investment to grow to $1,000,000.

BRUCE:

I/YR = 5; PV = -150,000; PMT = 0; FV = 1,000,000; and then solve for N = 38.88.

BRENDA:

I/YR = 10; PV = -150,000; PMT = 0; FV = 1,000,000; and then solve for N = 19.90.

Step 2:  Calculate the difference in the length of time for the accounts to reach $1 million:

Bruce will be able to retire in 38.88 years, or 38.88 – 19.90 = 19.0 years after Brenda does.

17.     Remaining loan balance Answer: a  Diff: E  N

Step 1:       Solve for the monthly payment:

                  Enter the following input data in the calculator:

                  N = 60; I = 12/12 = 1; PV = -15,000; FV = 0; and then solve for PMT = $333.6667.

Step 2:       Determine the loan balance remaining after the 30th payment:

1 INPUT 30 n AMORT

= displays Int:  $3,621.1746

= displays Prin:  $6,388.8264

= displays Bal:  $8,611.1736.

Therefore, the balance will be $8,611.17.

18                          Work out how much Karen will have saved by age 65:

                  Enter the following inputs in the calculator:

N = 41; I = 10; PV = 0; PMT = 5,000; and then solve for FV = $2,439,259.

Required annuity payments Answer: b  Diff: M  N

19:       Figure the payments Kathy will need to make to have the same amount saved as Karen:

Enter the following inputs in the calculator:

N = 36; I = 10; PV = 0; FV = 2,439,259; and then solve for PMT = $8,154.60.

20.   Bond concepts                                         Answer: a  Diff: E

Statement a is correct; the other statements are false.  A bond’s price and YTM are negatively related.  If a bond’s YTM is greater than its coupon rate, it will sell at a discount.

2[1].   Bond value--semiannual payment                        Answer: b  Diff: E

N = 15 ´ 2 = 30; I/YR = 11/2 = 5.5; PMT = 1,000 ´ 0.08/2 = 40; FV = 1000; and then solve for PV = -$781.99. V_B = $781.99.

22.   YTM and YTC--semiannual bond                          Answer: e  Diff: E

To calculate YTM:

N = 28; PV = -1075; PMT = 40; FV = 1000; and then solve for I/YR = 3.57% ´ 2 = 7.14%.

To calculate YTC:

N = 10; PV = -1075; PMT = 40; FV = 1050; and then solve for I/YR = 3.52% ´ 2 = 7.05%.

23.   Bond value--semiannual payment                        Answer: d  Diff: E

Financial calculator solution:

Inputs: N = 40; I = 5; PMT = 40; FV = 1000.

Output: PV = -$828.41; V_B » $828.

24.   Current yield and yield to maturity                   Answer: b  Diff: E

Current yield is calculated as:  $80/$985 = 8.12%.

N = 12; PV = -985; PMT = 80; FV = 1000; and then solve for I/YR (YTM) = 8.20%.

25.   Bond coupon rate                                      Answer: c  Diff: M

Tabular solution:

  $768 = (PMT/2)(PVIFA_5%,10) + $1,000(PVIF_5%,10)

       = (PMT/2)(7.7217) + $1,000(0.6139)

154.10 = (PMT/2)(7.7217)

 PMT/2 = $19.96 » $20

   PMT » $40 and coupon rate » 4%.

Financial calculator solution:

Inputs: N = 10; I = 5; PV = -768; FV = 1,000.

Output: PMT = $19.955 (semiannual PMT).

Annual coupon rate = (PMT ´ 2)/M = ($19.955 ´ 2)/$1,000 = 3.99% » 4%.

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