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11. As a result of a change in strategy to selling differentiated products at premium prices, a company’s gross margin ratio increased by 5% (i.e., from 35% to 40%). The most likely effect on the company’s operating margin ratio as a result of the change in strategy would be an increase: A. equal to 5%. B. less than 5%. C. greater than 5%.

Ans: B. A strategy of selling differentiated products at premium prices usually requires additional advertising or research and development to support the differentiating features, therefore, the effect on operating profit is normally less than the effect on gross profit margin.

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12.  An analyst gathers the following information about 2011 actual results for a company and its projected sales, COGS, and assets for 2012: 2011actual 2012projected Sales ￡9,000,000 ￡9,900,000 COGS ￡3,000,000 ￡3,450,000 Total assets ￡4,500,000 ￡4,450,000 Current assets ￡1,800,000 Current liabilities ￡1,200,000 Based on the projected sales increase, the best estimate of 2010 projected current assets is closest to: A. ￡1,890,000. B. ￡1,980,000. C. ￡2,070,000.

Ans: B. Current assets are sales driven and hence would be expected to increase by 10%, the same amount as sales. The increase is sales is (9,900,000-9,000,000)/9,000,000=10%. Therefore, projected current assets are 1.10x1,800,000=1,980,000

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13. When preparing pro forma income statements, which one of the following items is least likely to be sales driven? A. Current assets. B. Interest expense. C. Administrative expenses.

Ans: B. Interest expense is considered a fixed burden and a function of a firm’s capital structure, not sales. A is incorrect. Current assets are normally a sales driven account. C is incorrect. Administrative expenses, although they may contain fixed costs, are primarily sales driven.

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14. Which of the following pairs of general categories are least likely to be considered in the formulas used by credit rating agencies to determine the capacity of a borrower to repay a debt? A. Operational efficiency; leverage. B. Margin stability, availability of collateral. C. Leverage; scale and diversification.

Ans: B. The four general categories are: (1) scale and diversification, (2) operational efficiency, (3) margin stability, and (4) leverage. Larger companies and those with more different product lines and greater geographic diversification are better credit risks. High operating efficiency indicative of a better credit risk. Stable profit margins indicate a higher probability of repayment and thus, a better credit risk. Firms with greater earning in relation to their debt level are better credit risks. While the availability of collateral certainly reduces lender risk, it is not one of the general categories used by credit rating agencies to determine capacity to repay. Specifically, they would consider (1) several specific accounting ratios and (2) business characteristics. The availably of collateral falls into neither category.

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15. A firm presents the following income statement, which complies with the standards under which it must report: Sales 20,535 COGS 14,525 Operating expenses 2,530, Operating income 3,480 Income taxes 1,220 Income from continuing operations 2,260 Extraordinary items, net of tax (525) Net income 1,735 Based on the differences between U.S.GAAP and International Financial Reporting Standards, this firm: A. must report any dividends received as operating cash flows. B. is permitted to recognize upward revaluations of long-lived assets. C. cannot have used LIFO as its inventory cost assumption.

Ans: A. The income statement shows an extraordinary item, which is permitted under U.S.GAAP but not under IFRS. From this we can conclude that the firm reports under U.S.GAAP. U.S.GAAP requires dividends received to be classified as CFO, while IFRS allows them to be classified as either CFO or CFI. A firm reporting under U.S.GAAP may not revalue assets upward by may use LIFO.

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16. Which of the following effects is most likely to occur when using ratio screens for high dividend yield stocks and low P/E stocks, respectively? High dividend yield Low P/E ratios A Include too many financial services firms Exclude too many growth firms B Exclude too many financial services firms Include too many growth firms C Include too many financial services firms Include too many growth firms

Ans: A. Screening for high dividend yield stocks will likely include a disproportionately high number of financial services firms as such firms typically have higher dividend payouts. A screen to identify firm with low P/E ratios will likely exclude growth firms from the sample as high expected earnings growth leads to high P/Es.

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17. Yang Liu, CFA, is comparing the financial performance of a firm that presents its results under IFRS to that of a firm that complies with U.S.GAAP. the U.S. firm uses the LIFO method for inventory accounting, and the other firm uses FIFO method. If Liu performs the appropriate adjustments to make the U.S. firm’s financial statements comparable to the firm that reports under IFRS, her adjustments are least likely to change the firm’s: A. quick ratio. B. debt-to-equity ratio. C. cash conversion cycle.

Ans: A. The analyst should add the U.S.GAAP firm’s LIFO reserve to its balance sheet inventory and subtract the change in the LIFO reserve from its COGS. This adjustment will increase the firm’s total assets and change its pretax income, income taxes, net income, and retained earnings (increasing them if the LIFO reserve increased, or decreasing them if the LIFO reserve decreased). These adjustments will change the firm’s debt-to-equity ratio by changing total equity, and change the cash conversion cycle by changing inventories. The adjustments do not change current liabilities or current assets other than inventories, so the quick ratio is not affected.

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18. When comparing two firms, an analyst should most appropriately adjust the financial statements when they include significant: A. acquisition goodwill, if one of the firms reports under IFRS and the other under U.S.GAAP. B. property, plant, and equipment, if one of the firms uses accelerated depreciation and the other uses straight-line depreciation. C. unrealized losses from securities held for trading, if one of the firms uses fair value reporting for securities investments and the other does not.

Ans: B. Depreciation methods are an example of a difference that may require an analyst to adjust financial statements to make them comparable. Acquisition goodwill is treated the same way under IFRS and U.S.GAAP: it is not amortized but is tested for impairment at least annually. Securities held for trading are reported at fair value with unrealized gains and losses reported on the income statement.

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19.  Zhan Wang, CFA, is analyzing Bao Company by projecting pro forma financial statements. Zhan expects Bao to generate sales of $3 billion and a return on equity of 15% in the next year. Zhan forecasts that Bao’s total assets will be $5 billion and that the company will maintain its financial leverage ratio of 2.5. based on these forecasts, Zhan should project Bao’s net income to be: A. $100 million. B. $300 million. C. $500 million.

Ans: B. Based on the data given, use the basic DuPont equation and solve for expected net income. ROE=xx 0.15 = x x 2.5 =0.1 Net income =$300 million Alternatively, A/E=2.5 and assets = $5 billion, so equity=$2 billion.

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20. Firms that prepare their financial statements according to International Financial Reporting Standards are least likely to: A. use LIFO inventory accounting. B. use proportionate consolidation for a joint venture. C. recognize unrealized losses from held-for-trading securities in net income.

Ans: A. The LIFO inventory method is permitted under U.S.GAAP but is not allowed under IFRS. B is incorrect. Proportionate consolidation of joint ventures is permitted under IFRS but not under U.S.GAAP. C is incorrect. Unrealized gains and losses from held-for-trading securities are recognized on the income statement under both IFRS and U.S.GAAP.