Sample Exam

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Name_________________________________________________ Student ID Number______________________________________ International Financial Statement Analysis Midterm Exam 11 November, 2008 Instructions: You have 2.5 hours to complete the exam Please show all your calculations Please write clearly and in English so I can read your answers This is an open book exam Do not look at other people’s exams or attempt to obtain any information from other people If you have a question, please come to the front of the room to ask. However I may not answer the question. After all, this is an exam Make sure your exam has 14 multiple choice questions and 7 essays/problems o The multiple choice questions are worth 3 points each For those multiple choice questions requiring calculations, you must show those calculations to receive points. Partial credit will be awarded on those multiple choice questions requiring calculations o The essays/problems are worth 11 points each Only do 5 of the 7 essay/problems. You choose which 5 you do. Show all your work. Write clearly so I can read what you wrote. Partial credit is available on all essay questions. o The math wizards will note that equals 97 points. I am giving everyone 3 points for showing up. Yes, I am way too nice! Good Luck!

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Transcript of Sample Exam

Page 1: Sample Exam

Name_________________________________________________

Student ID Number______________________________________

International Financial Statement Analysis

Midterm Exam

11 November, 2008

Instructions:

You have 2.5 hours to complete the exam

Please show all your calculations

Please write clearly and in English so I can read your answers

This is an open book exam

Do not look at other people’s exams or attempt to obtain any information from other

people

If you have a question, please come to the front of the room to ask. However I may not

answer the question. After all, this is an exam

Make sure your exam has 14 multiple choice questions and 7 essays/problems

o The multiple choice questions are worth 3 points each

For those multiple choice questions requiring calculations, you must show

those calculations to receive points. Partial credit will be awarded on those

multiple choice questions requiring calculations

o The essays/problems are worth 11 points each

Only do 5 of the 7 essay/problems. You choose which 5 you do. Show

all your work. Write clearly so I can read what you wrote. Partial credit is

available on all essay questions.

o The math wizards will note that equals 97 points. I am giving everyone 3 points

for showing up. Yes, I am way too nice!

Good Luck!

Page 2: Sample Exam

Multiple Choice Questions

Choose the best answer. Also if calculations are required, please show your work. Some

partial credit may be awarded but only if I can understand how you arrived at your

solution. BE SURE IT IS CLEAR WHAT YOUR ANSWER IS (A, B, C, OR D)!!

1. If a company that leases equipment from another company records these leases as operating

leases rather than a capital leases, its:

(I) recorded liabilities will be lower

(II) recorded assets will be higher

(III) total cash flows will be higher

(IV) leverage ratios will be higher

A. I and III

B. II and IV

C. I only The answer is C

D. II, III and IV

2. Hert Corporation acquired a capital lease that is carried on its books at a present value of

$100,000 (discounted at 12%). Its annual rental payment of $15,000. What is the amount of

interest expense from this lease?

A. A above

B. B above

C. C above

D. D above

The answer is B: First Year: 100,000 x 12% = $12,000 so $3,000 reduces

principal; Second Year: $97,000 x 12% = $11,640 in interest

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3. If a company engages in off-balance sheet financing generally the effect is:

(I) to cause assets to be understated

(II) to increase leverage ratios

(III) to increase cash flows

(IV) to cause liabilities to be understated

A. I, II, III and IV

B. I, III and IV

C. I and IV

D. IV only

The answer is C as you get both assets and liabilities off the books

4. A company's current ratio is 1.5. If the company uses cash to retire notes payable due within

one year, would this transaction increase or decrease the current ratio and return on assets

ratio?

A. Current Ratio: Increase; Return on Assets: Increase

B. Current Ratio: Increase; Return on Assets: Decrease

C. Current Ratio: Decrease; Return on Assets: Increase

D. Current Ratio: Decrease; Return on Assets: Decrease

The answer is A. Just do a numeric example. Current Ratio = 150/100 = 1.5. Pay

off 10 in current liabilities, now it is 140/90 = 1.55

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Use the following information to answer questions 5 and 6

The following information can be found in Manufacturer Company's financial statements.

5. If Manufacturer used FIFO its retained earnings as of the end of fiscal 2005 would be:

A. $ 540,000

B. $ 440,000

C. $ 524,000

D. $ 506,000

The answer is C: $500,000 + ($40,000 x 60%)

6. If Manufacturer used FIFO its Net Income for fiscal 2005 would be:

A. $ 165,000

B. $ 149,000

C. $ 135,000

D. $ 131,000

The answer is D: $125,000 + (($40,000 - $30,000)x 60%

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Use the following information to answer questions 7 to 10

Parent Company Inc. successfully bids for Child Company Inc. in year X1. Parent Company Inc.

has purchased all of Child's shares outstanding for $8,500. Following are excerpts from both

companies' financial statements for year X1, prior to the acquisition.

Also assume the following information: the acquisition was accounted for using the purchase

method. $1,500 of the excess price relates to depreciable assets, and those assets have an additional

useful life of 10 years at the time of the acquisition. Parent Company Inc. uses the straight line

depreciation method and has a 34% tax rate. The combined net income for both companies for year

X2 (excluding any expenses that need to be recorded as a result of the purchase method accounting

for the merger) was $1,560.

7. What would be total liabilities in the consolidated financial statements for the date in which the

merger became effective, assuming any excess purchase price relates to goodwill?

A. $28,221

B. $27,231

C. $27,741

D. $25,462

The answer is B: $23,467 + $3,764

8. What would be total assets in the consolidated financial statements for the date in which the

merger became effective, assuming any excess purchase price relates to goodwill?

A. $50,008

B. $49,498

C. $41,508

D. $44,113

The answer is B: $37,234 + $5,379 +($8,500 - $1,615)

9. What would be net income in the consolidated income statement for year X2?

A. $1,461

B. $1,560

C. $1,450

D. $1,611

The answer is A: $1,560 – (($1,500 / 10) x 66%)

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10. What would be net income in the consolidated income statement for year X2 assuming any

excess purchase price relates to goodwill, and goodwill was found to be impaired by $830?

A. $1,461

B. $1,560

C. $1,012.2

D. $730

The answer is C: $1,560 – ($830 x 66%)

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Brierton Company enters a contract at the beginning of year 1 to build a new federal

courthouse for a price of $16 million. Brierton estimates that total cost of the project will be

$12 million, and will take four years to complete.

11. If Brierton used percentage-of-completion method to account for this project, what would

they have reported as profit in year 2?

A. $ 0

B. $ 1.333M

C. $ 1.5M

D. $ 0.667M

The answer is B: (4/12) x ($16 million - $12 million) where they incurred $4

million of the total $12 million in costs in Year 2

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Use the following information to answer questions 12 to 14

The following information was extracted from Smurm Corporation's 2005 annual report:

12. Basic earnings per share for 2005 was:

A. $3.50 Pref Stock Div = 50 million shares x $10 par x 10% = $50 million

B. $3.16 # of shares = 90 million + (10 million x 9/12 of the year) = 97.5 million

C. $3.08

D. $3.00

The answer is C: ($350 million - $50 million) / 97.5 million shares

13. Using the treasury stock method, the options would result in how many extra shares being

recognized in the diluted EPS calculation:

A. 500,000

B. 358,975

C. 333,333

D. 285,714

The answer is C: 50 million shares / $75 per share = 666,667 shares bought so

you need an additional 333,333 shares to be issued

14. Diluted earnings per share for 2005 was:

A. $1.52

B. $1.77

C. $2.00

D. $2.03

The answer is B: $350 million / (97.5 million (a) + .333333 million (b) +100

million) where the last 10 million is 50 million in P/S converted to C/S

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Essays/Problems

Please write clearly and show any calculations you make

15. Valuation of Bonds

(a) It is January 1, 2006 and you are considering buying $20,000 of Hilever Company's

10% bonds, which come due on December 31, 2015. The bonds pay interest semi-

annually on June 30 and December 31 of each year. The prevailing interest rate on bonds

of similar risk is 12%. How much would you be prepared to pay for the bond?

(b) If coupon rate was 12% on these bonds, how much would you be prepared to pay?

(c) If the coupon rate was 10% and the bonds were convertible into common equity (5

shares for every $1,000 face value coupon bond), and common stock is currently trading

at $11 per share would this change your answer to part a? Why? Why not?

Part a: (n= 20 and i = 6) since these are semi-annual payments. There are 20 semiannual

periods in 10 years at an interest rate of 6% per semiannual period.

Interest: $20,000 x 10% x 6/12 = $1,000 x 11.46992 = $11,470

Principal: $20,000 x .3118 = $ 6,236

$17,706

Part b: It has to be $20,000 since the stated (coupon) rate and the market rate are both 12%

Part c: The price will be a little higher than $17,706 but not much higher given that the stock

price is currently at $11 and the break even point is $200 ($1,000 bond / 5 shares)

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16. Earnings Management

Earnings management can be defined as the "purposeful intervention by management in the

earnings process, usually to satisfy selfish objectives" (Schipper, 1989).

Earnings management techniques can be separated into those that are "cosmetic" (without

cash flow consequences) and those that are "real" (with cash flow consequences).

The management of a company wishes to increase earnings this period.

List three "cosmetic" techniques they could use to achieve this objective and explain why

they will achieve the objective

There are lots of possible answers here. The key was to be specific. Some possible

answers were:

Decrease bad debt expense

Decrease warranty expense

Increase salvage value of depreciable assets

Increase the useful life of depreciable assets

Change from accelerated depreciation to straight-line depreciation

Change from LIFO to FIFO

Capitalize expenses like R&D if possible

Increase the discount rate on the pension plan

Increase the expected rate of return on the pension plan assets

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17. Leases

Compare the effects of operating leases as compared to capitalized leases, in the first year of

a lease, on the following items listed. Explain your answer.

(1) EBIT

(2) Net Income

(3) Return on Assets (levered)

(4) Cash flow from Operations

(5) Current Ratio

Ratio/Measure Operating Lease Capital Lease Which is Better

EBIT (Earnings

Before Interest

and Taxes)

Rent expense (the full cash

flow)

Just the portion of the

expense associated with

depreciation

Capital Lease

Net Income Rent expense Depreciation expense +

the portion of the cash

flow associated with

interest expense

Operating

Lease

ROA (Return On

Assets)

Higher Net Income re (2)

above

Higher asset number

since leased asset is on

the balance sheet

Operating

Lease

Cash Flow from

Operations

Rent Expense (the full cash

flow)

Just the cash flow

associated with interest

expense. The rest of the

cash flow will pay down

the Lease Liability

Capital Lease

Current Ratio Current Assets and Current

Liabilities are unaffected

Current Assets are

unaffected but Current

Liabilities are higher due

to the current portion of

the long-term lease

obligation

Operating

Lease

Page 12: Sample Exam

18. Operating Leases

Retail Inc. has both operating and capital leases. Below is a portion of its lease footnote taken

from their 2005 financial statements.

(a) Obtain a crude estimate of the remaining length of the operating and capital leases

(b) Estimate the interest rate implicit in the capital leases (Note: No trial and error needed.

The information is above where this should be an easy calculation). If you cannot get the

answer, come to me and I will give you the answer but you will not receive as many points.

(c) Compute the present value of the operating leases

Part a: Capital Lease: $1,050 / $145 per year = 7.2 additional years + 2006 to 2010 =

12.2 years. Operating Lease: $5,941 / $528 per year = 11.25 additional years + 2006 to

2010 = 16.25 years

Part b: $233 payment in 2006 - $100 of that reducing the principal balance means $133

is interest divided by the present value of the obligation of $1,328 = 10%

Part c: $8659 / 16 years (a) = $541.19 x 7.82371 (n=16; i=10 (b)) = $4,234

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19. Equity method versus cost method

Wilde Corporation owns 30% of the outstanding stock of Bernie Inc. Bernie recorded net

income of $10M and paid dividends of $3M in 2005. For each of the following ratios, state

the effect (higher, lower or no effect) that the use of the equity method would have on

Wilde's financial ratios compared to the use of the cost method in 2005. Explain your

answers.

(i) Gross margin

(ii) Total Asset turnover

(iii) Cash flow from operations to current liabilities

(iv) Debt to Equity

Equity Method transactions are: LT Investment(asset) increases $3,000,000 and

Investment Income increases $3,000,000 and Cash increases $900,000 and LT

Investment decreases $900,000

Versus the Cost Method which is only Cash increases $900,000 and Investment Income

increases $900,000

Part (i): Gross Margin is Gross Margin / Sales which is unaffected by the transactions

above

Part (ii): Total Asset Turnover is Sales / Total Assets. Sales is unaffected by the

transactions above but assets are larger under the equity method so the ratio will be

lower under the equity method

Part (iii): Cash flow from operations to current liabilities is unaffected by the

transactions above.

Part (iv): Debt to Equity: Debt is unaffected by the transactions above but the equity

method will recognize more investment income so the equity method will have a higher

net income so the equity method will have a lower debt to equity ratio.

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20. Foreign Currency Translation

(a) Gruber PLC operates in England and is a subsidiary of Szudy International. The

functional currency of Gruber is the British pound. Gruber reported net income in 2005 of

£350M and paid a £75M dividend on July 1, 2005 when the exchange rate was $1.55 per

pound. The current rate is $1.65 per pound and the average rate for 2005 was 1.60. Compute

the change in retained earnings for the period in US dollars.

(b) Windsor PLC operates in England and is a subsidiary of Buckingham International. The

U.S. dollar is the reporting currency for Buckingham international. The functional currency

of Windsor is the British pound, and it prepares financial information in British pounds for

internal use.

Windsor's 2003 and 2004 net assets were 10,000 and 11,500, respectively. The 12/31/04

exchange rate was 1.56, the 12/31/03 exchange rate was 1.50 and the average rate for the

year was 1.53.

What was the translation gain or loss for the year for Buckingham when it converted

Windsor's financial statements into the reporting currency?

Part a: The effect on retained earnings is the increase due to net income and the decrease

due to Dividends

+ Net Income: 350,000,000 x $1.60 = $560,000,000

- Dividends: 75,000,000 x $1.55 = (116,250,000)

$443,750,000

Part b:

Beginning of the year balance x change in exchange rates (10,000 x (1.56-1.50) = 600

+ Increase in net assets x (end of the year – average exchange rate) 1,500 x (1.56-1.53)

= 45

Total = 645 and since the pound strengthened relative to the dollar, this is a translation

gain

Page 15: Sample Exam

Problem 21: Financial Footprints- Identify Company1

In this problem, you become a financial analyst/detective. The attached exhibit expresses

condensed financial statements for 13 companies on a percentage basis. In the income statement,

all figures are presented as a percentage of total sales revenue. In the balance sheet, all figures

are presented as a percentage of total assets. The 13 companies (all corporations except for the

accounting firm) shown here represent the following industries:

(1) Advertising agency.

(2) Computer manufacturer.

(3) Department store chain (that carries its own receivables).

(4) Distiller of hard liquor.

(5) Electric utility.

(6) Finance company (lends money to consumers).

(7) Grocery store chain.

(8) Insurance company.

(9) Pharmaceutical company.

(10) Public accounting (CPA) partnership.

(11) Soft drink company.

(12) Steel manufacturer.

(13) Tobacco products company.

Use whatever clues you can to match the companies in the attached exhibit with the industries

listed above. You must also give a brief explanation (2 to 3 sentences) justifying each of

your choices.

1 Adapted from Clyde P. Stickney & Roman L. Weil, Financial Accounting: An Introduction to Concepts, Methods,

and Users, 7th Edition, Dryden Press, 1994.

Page 16: Sample Exam

The way I graded this problem was that the groupings of companies had to make sense. I

allowed for variations within the group, but the companies in the groups had to make sense. So

below are the four groups I split the 13 companies above into and in parentheses is the actual

answer from the spreadsheet.

First group: Those companies without inventories, i.e. service industries. Given the note at the

bottom of the spreadsheet, this group should have been obvious. The companies in this group are

the advertising agency (12), finance company (13), insurance company (11) and public

accounting (CPA) partnership (2)

Second group: These are the companies with high R&D. They are the computer manufacturer

(9) and the pharmaceutical company (3)

Third group: This is the group with high levels of property, plant and equipment. They are the

electric utility (10), the grocery store (1) and the steel manufacturer (8)

Fourth group: This is essentially the “other” group. They don’t fit into categories so easily.

These companies are the department store chain (5), the distiller of hard liquor (6), the soft drink

company (7) and the tobacco products company (4)

Some brief explanations based on the spreadsheet columns:

Company 1: the grocery store. Lots of fixed assets. Lots of inventory and a terrible profit margin

of only 1.9%

Company 2: the CPA firm. They have multiple offices so of the no inventory companies they have

the most PPE

Company 3: the pharmaceutical. Of the two high R&D companies, they have the most intangible

assets on the patents for their drugs. Their PPE requirements are lower than the computer

manufacturer.

Company 4: tobacco. They can’t advertise so they have the lowest advertising expense. The other

expenses are legal fees for being sued by almost everyone.

Company 5: the department store: high receivables and a relatively high amount of inventory

coupled with high (for this group) PPE because of their stores

Company 6: liquor. This is the one that basically falls out as the others are all identified. But

they can advertise and they do but not as much as company 7

Company 7: soft drink. Highest advertising rate in this group and the least amount of inventory

as they turn their inventory quickly.

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Company 8: steel. Huge PPE and not a great profit margin as the cost of production is high and

they are in a competitive business.

Company 9: computers. See the explanation for company 3except it is the opposite.

Company 10: utility. Huge PPE. Yes they have inventory as utilities sell stuff just not a lot of

stuff. Good profit margin but not that high as they are regulated.

Company 11: insurance company. Huge amount of receivables and current liabilities associated

with their premiums being collected and their claims being paid.

Company 12: advertising. Within this group, this is the one that just had to go somewhere.

Company 13: finance company. Massive interest expense because they borrow so they can lend

money. Relatively small operating costs.