Past MA exams by lecture topic – questions

Covered: every exam question from Nov-Dec 2013, Mar-Apr 2014, Nov-Dec 2014, Mar-Apr
2015, and Nov-Dec 2015.

Session 1 How costs behave; CVP

1. (3 points) Which statement is FALSE?

a. Higher operating leverage results in a great risk of loss.
b. Higher operating leverage results in accelerated profits above the breakeven point.
c. Higher operating leverage is an outcome of the cost function has a higher proportion
of fixed costs relative to variable costs.
d. A firm’s degree of operating leverage depends primarily on sales variability.
e. None of the above.

2. (3 points) One North Corp. manufactures two products: the Dover and the Heritage. The
following information was gathered:
Dover Heritage
Selling price per unit $17.00 $22.00
Variable cost per unit $12.00 $18.00
Fixed costs per unit $6.00 $5.00

All fixed costs represent contractual obligations that One North Corp. cannot avoid.

If One North Corp. could produce and sell either 9,000 units of Dover or 10,000 units of
Heritage at full capacity, it should produce and sell:

a. 10,000 units of Heritage and none of Dover

b. 5,000 units of Heritage and 4,500 units of Dover
c. 9,000 units of Dover and none of Heritage
d. Make neither Dover nor Heritage
e. It is indifferent whether Dover or Heritage is produced

3. (3 points) If your firm changed its cost structure to make more of its costs fixed and less of its
costs variable, which of the following statements is TRUE?
a. Your firm will have lower operating leverage and a greater risk of loss
b. Your firm will have lower operating leverage and a lower benefit as sales increase
c. Your firm will have higher operating leverage and a greater risk of loss
d. Your firm will have higher operating leverage and a lower benefit as sales increase
e. Your firm’s operating leverage will not change

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4. Henry produces environmentally friendly Geese Pens from his California ranch, which he sells
to farmers that make non-force-feeding Foie Gras. A print-off of income statement for the last
four years is presented as follows:

2011 2012 2013 2014

Sales Revenue $96,000 $120,000 $164,000 $180,000

Cost of Goods Sold $54,000 $67,500 $92,250 $101,250
Gross Margin $42,000 $52,500 $71,750 $78,750
Website Expense $12,000 $12,000 $12,000 $12,000
Salesperson Wages Expense $32,000 $35,000 $40,500 $42,500
Donations/Lobbying Expense $6,000 $7,500 $10,250 $11,250

Net Income before tax ($8,000) ($2,000) $9,000 $13,000

Henry always sells his Geese Pens for $80. Given high demand and superior quality, Henry has
always sold all Geese Pens he has produced. It is expected that 2015 will exhibit similar cost
behavior to the previous four years.

(1) (4 points) Express Henry’s net income before tax as a function of the number of Geese Pens
(units) sold. (i.e. write the profit function).

(2) (4 points) Henry is subjected to a tax rate of 20%. Assuming Henry wants to achieve an
income after tax of profit of $30,000. What is the revenue (in dollars) for Henry to achieve an
after-tax annual target income of $30,000?

$ .

(3) (2 points) What advice, if any, would you offer Henry concerning the above profit estimate.
(Write your reasoning below in 10 words or less).

5. Shenzhen Inc. manufactures skateboards. Monthly production is at 2,000 skateboards. Raw

materials and salary for factory workers are variable costs, all other costs are fixed costs.
Shenzhen sells skateboards for ¥100 each. Shenzhen’s November monthly manufacturing cost
and other expense data are as follows.

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 Raw materials ¥95,000
Utility expense for factory 5,000
Supplies for marketing office 1,000
Salary for factory assembly-line workers 60,000
Depreciation on factory building and equipment 7,000
Depreciation on administrative office equipment 500
Salary for factory's manager 6,500
Insurance on factory building and equipment 2,500
Advertisement for skateboards 9,000

(1) (3 points) What are the period costs for November ¥_________________
Production Costs
Direct Direct Manufacturing Period
Materials Labor Overhead Costs
Raw materials
Utility expense for factory
Supplies for marketing office
Salary for factory assembly-line workers
Depreciation on factory building and equipment
Depreciation on administrative office equipment
Salary for factory's manager
Insurance on factory building and equipment
Advertisement for skateboards

(2) (3 points) What is the production cost to produce one skateboard? ¥________________
Total production costs
Direct materials
Direct labor
Manufacturing Overhead
Total production costs

(3) (3 points) Assuming Shenzhen Inc. had no beginning inventory and sold 1,500 skateboards in
November. What is the net income for November?

¥__________________

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(4) (3 points) Assume that Shenzhen has plenty of capacity. If a one-time unique customer not in
the normal marketing channels (e.g, an alien) approached Shenzhen Inc. to buy a skateboard in
November what is the lowest price that Shenzhen Inc. could offer and not destroy firm value?
(Put another way, what is the lowest price acceptable to Shenzhen?)

¥___________________

(5) (4 points) Assuming Shenzhen Inc. was only going to produce the number of skateboards that
it sold. What is the number of skateboards Shenzhen needs to produce and sell in a month to
break-even?
______________________skateboards

(6) (3 points) Shenzhen Inc. has a corporate tax rate of 20%. Assuming again that Shenzhen Inc.
was only going to produce the number of skateboards that it sold. What is the total revenues in
stakeboards Shenzhen needs to produce and sell in a month to achieve an after tax-profit in the
month of ¥10,000?

¥_____________________

(7) (3 points) If Shenzhen Inc. increased the production of skateboards without increasing sales
in November would this: a) increase net income, b) decrease net income; c) have no effect on net
income? Briefly explain why in 30 words or less

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Session 2 Product costing

1. (3 points) Which of the following is NOT in cost of goods sold?

a. indirect materials
b. direct materials
c. factory lighting
d. manufacturing supervisor salaries
e. all the above are in cost of goods sold

2. (3 points) Avon Corp. manufactures three products: the Seine, the Marne, and the Loing. The
following information was gathered:

Seine Marne Loing

Selling price per unit €20 €15 €10
Contribution margin per unit €11 €7 €2.5
Machine hours per unit 1 0.5 0.2

Total fixed costs for the period were $20,000 and represented contractual obligations that Avon
Corp. cannot avoid. Given demand for all three products and a limited number of machine hours
available, which product should you produce first?

a. Seine
b. Marne
c. Loing
d. Make none of them
e. Insufficient information to make right choice

3. (3 points) Which costs are recorded and reported by a financial accounting system?
a. marginal costs
b. agency costs
c. opportunity costs
d. full costs
e. avoidable costs

4. (3 points) Rewarding Revision Manufacturing Company produces two products for which the
following data have been tabulated. Fixed manufacturing cost is allocated at a rate of $1.00 per
machine hour.

Per unit: Product A Product B

Selling price $4.00 $3.00
Variable manufacturing cost $2.00 $1.50

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Fixed manufacturing cost $0.75 $0.20
Variable SG&A cost $1.00 $1.00

The sales manager has had an increase in the budget allotment for advertising and wants to apply
the money to the most profitable product. The products are not substitutes for one another in the
eyes of the company's customers.

Rewarding Revision has only 100,000 machine hours that can be made available to produce
additional units of products A and B. If the potential increase in sales units for either product that
results from the advertising is far in excess of this production capacity, which product should be
advertised and what is the estimated increase in total contribution margin?

a. Product B, yielding a contribution margin greater than $200,000

b. Product B, yielding a contribution margin between $150,000 and $200,000
c. Product A, yielding a contribution margin between $100,000 and $150,000
d. Product A, yielding a contribution margin between $0 and $100,000
e. None of the above

5. (3 points) Action Products sells Product A at a selling price of $21 per unit. Action’s cost per
unit based on full capacity of 200,000 units is as follows:

Direct materials $4
Direct labor $5
Overhead $6
$15

Direct material and direct labor costs are all variable. Total overhead costs include $800,000 in
fixed overhead with the remainder being variable.

A special order offering to buy 20,000 units was received from an overseas distributor. The only
marketing costs that would be incurred on this order would be $3 per unit for shipping. Action has
sufficient existing capacity to manufacture the additional units. In negotiating a price for the
special order, Wagner should consider that the minimum selling price per unit needed to maximize
short-term profits to be:

a. $18
b. $16
c. $15
d. $14
e. $ 9

6. (3 points) Which statement is TRUE?

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 a. available technology to gather information about the cost affects the direct/indirect
classification of a cost
b. all direct costs are variable costs
c. all variable costs are direct costs
d. all fixed costs are indirect costs
e. the level of budgeted profit for the next year affects the direct/indirect classification
of a cost

7. (3 points) Which statement is TRUE?

a. actual costing provides faster feedback than normal and standard costing.
b. standard costing is more accurate than actual and normal costing.
c. under actual costing indirect costs are directly traced to cost objects.
d. actual costing provides slower feedback than normal and standard costing.
e. both A and B.

8. (3 points) For 2014, Durian Breese uses labour hours as the only overhead cost-allocation base.
The accounting records contain the following information:

Actual Estimated
Manufacturing overhead costs $105,000 $125,000
Labour hours 20,000 25,000

Using normal costing (and before any end-of-year adjustments), what is the overapplied or
underapplied overhead during 2014?
a. More than $6,000 overapplied overhead
b. Between $1 and $6,000 overapplied overhead
c. No overapplied or underapplied overhead
d. Between $1 and $6,000 underapplied overhead
e. More than $6,000 underapplied overhead

9. (4 points) Urs Company manufactures snowboards. Estimated costs for Year 1 were as
follows.

Direct labor ...............................................................$31,000

Bonuses paid to factory supervisors .............................9,000
Interest expense ...........................................................32,000
Depreciation on manufacturing equipment .................18,000
Indirect labor ...............................................................11,000
Direct materials ...........................................................36,000
Income tax expense .....................................................26,000
Indirect materials ........................................................14,000
Property taxes on the corporate office building ..........18,000

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Estimated direct labor hours were 40,000.

Actual data for Year 1 are as follows.

• Total manufacturing overhead: $120,000
• Direct labor hours: 60,000 hours

The predetermined manufacturing overhead rate is determined on the basis of direct labor hours.
What is the amount of over- or underapplied overhead for Urs Company for Year 1?

a. $16,000 OVERapplied
b. $10,000 UNDERapplied
c. $26,000 UNDERapplied
d. $42,000 UNDERapplied
e. None of the above

10. (3 points) Zemsky uses a single raw material in its production process. The standard price for a
unit of material is $7.00. During October the company purchased and used 10,000 units of this
material. The actual purchase price was $8.00 per unit. The standard quantity required per finished
product is 3 units. Zemsky produced 3,000 finished units of the final product in October. How
much was the material price variance for October?

a. $3,000 favorable
b. $3,000 unfavorable
c. $9,000 unfavorable
d. $10,000 unfavorable
e. none of the above

11. (3 points) During 2012, Dr. Feelgood Labs supplied hospitals with a comprehensive
diagnostic kit for $120. At a volume of 50,000 kits, Dr. Feelgood had fixed costs of $1 million
and operating income before income taxes of $200,000. Because of an adverse legal decision,
Dr. Feelgood’s year 2013 liability insurance has increased by $1.0 million over 2012. Assuming
that the volume and other costs are unchanged, what should the 2013 price be if Dr. Feelgood is
to make the same $200,000 operating income before income taxes? (Assume that Dr. Feelgood
has no beginning or ending work-in-process or finished goods inventories.)

12. (3 points) Increasing production in the current period will increase net income in the current
period if:

a. the firm uses US GAAP or IFRS and there are fixed manufacturing costs
b. the firm uses variable costing and there are fixed manufacturing costs
c. the firm uses US GAAP or IFRS and there are no fixed manufacturing costs

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 d. the firm uses variable costing and there are no fixed manufacturing costs
e. the firm uses a non-US GAAP or non-IFRS method to determine net income

13. (3 points) Robin Hood sells “the Bow” at a selling price of $23 per unit. Robin Hood’s cost
per unit based on full capacity of 400,000 units is as follows:

Direct materials $6
Direct labor $5
Overhead $6
$17

Direct material and direct labor costs are all variable. Total overhead costs include $1,200,000 in
fixed overhead with the remainder being variable.

A special order offering to buy 10,000 units was received from an overseas distributor. The only
marketing costs that would be incurred on this order would be $1 per unit for shipping. Robin
Hood has sufficient existing capacity to manufacture the additional units. In negotiating a price for
the special order, Robin Hood should consider that the total minimum selling price needed to
maximize short-term profits to be:

a. $170,000
b. $150,000
c. $140,000
d. $80,000
e. none of the above

14. (3 points) What is NOT a countermeasure for absorption costing manufacturing manipulation
schemes?
a. Using US GAAP or IFRS accounting standards
b. Not linking compensation to net income
c. Using variable costing for performance measurement
d. Lengthen the period used to evaluate performance
e. Incorporate an internal carrying charge for inventory

15. (4 points) Cuban Motors current customer demand is 90,000 cars per year. It sells its cars for
$25,000 each. Based on the planned 100,000 units of production, the expected cost per car is
$15,000, which includes $750 million worth of fixed costs. The CEO of Cuban Motors intends to
increase production to 150,000 units for no reason. Assume Cuban Motors has capacity to make
additional cars and uses IRFS for accounting purposes. Which of the following statements is
TRUE regarding the decision to produce more cars?
a. the decision will increase the cost per car in the current year
b. the decision will most likely reduce total inventory costs
c. the decision will increase net income by $375 million in the current year

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d. the decision will increase net income by $225 million in the current year
e. the decision will have no effect on net income in the current year

16. Robin Hood uses a predetermined (budgeted) overhead rate based on direct labour hours
(DLHs) to apply manufacturing overhead to products. At the beginning of the year, the Robin
Hood estimated manufacturing overhead would be $200,000 and DLHs would be 20,000. The
actual figures for the year were $215,000 for manufacturing overhead and 21,000 DLHs. Robin
Hood is NOT required to pay income tax and only makes one product.

(1) (3 points) Before any end-of-year accounting adjustments, how much has Robin Hood over-
applied or under-applied in overhead to their product costs during the year?

(2) (3 points) All over or under-allocated overhead (the difference between manufacturing
overhead incurred and applied) for the period is closed to COGS. Assuming only half of the units
produced by Robin Hood are sold in the current year, how much greater/less would Robin
Hood’s net income be if the company used actual costing instead of normal costing?

(3) (3 points) All over or under-allocated overhead (the difference between manufacturing
overhead incurred and applied) for the period is closed to COGS. Assuming all units produced
by Robin Hood are sold in the current year, how much greater/less would Robin Hood’s net
income be if the company used actual costing instead of normal costing?

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Session 3 Cost allocation

1. (3 points) Jakarta Ltd. manufactures two products: A, which has a relatively high labour
content; and B, which requires relatively high machine hours. If Jakarta Ltd. switches from
allocating overhead on the basis of direct labour hours to allocating overhead on the basis of
machine hours, which of the following is likely to be TRUE?

a. the profitability of A and B will increase

b. the profitability of A and B will decrease
c. the profitability of A will increase and the profitability of B will decrease
d. the profitability of A will decrease and the profitability of B will increase
e. the profitability of A will remain unchanged, but profitability of B will decrease

2. (3 points) For 2013, Boar’s Breath Manufacturing uses machine-hours as the only overhead
cost-allocation base. The accounting records contain the following information:

Estimated Actual
Manufacturing overhead costs $100,000 $120,000
Machine-hours 20,000 25,000

Using normal costing (and before any end-of-year adjustments), the amount of manufacturing
overhead costs allocated during 2013 is:

a. $150,000
b. $125,000
c. $120,000
d. $100,000
e. none of the above

3. (3 points) Using the accounting records from above, if Boar’s Breath Manufacturing used actual
costing, (and before any end-of-year adjustments) the amount of manufacturing overhead costs
allocated during 2013 is:

a. $150,000
b. $125,000
c. $120,000
d. $100,000
e. none of the above

4. (3 points) Which statement is TRUE?

a. When allocating costs from interrelated departments, the direct method produces the
most accurate costs

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 b. Ability-to-bear allocation methods are commonly regarding as better for decision
making
c. Revenue allocations are not as arbitrary as cost allocations
d. When allocating costs from interrelated departments, the reciprocal method produces
the most accurate costs, but due to its complexity it is not as commonly used as the
direct method
e. Ability-to-bear allocation methods are commonly regarding as better for addressing
agency issues

5. (2 points) “All allocations of indirect costs are arbitrary to some degree, in that if you use a
different allocation approach you get different profitability results. Therefore, in the interest of
removing cost distortions it is preferable where possible to not allocate indirect costs to cost
objects.” Do you agree or disagree; why? (Briefly explain in 20 words or less.).

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Session 4 Activity-based costing; The costing of everything

1. (3 points) Ilian Corporation has used a traditional cost accounting system to apply purchasing
costs uniformly to all products at a rate of 15% of direct labor cost. Monthly direct labor cost for
its main product is $30,000. In an attempt to distribute purchasing costs more equitably, Ilian is
considering activity-based costing (ABC). The monthly data shown below have been gathered
for the main product. The three activities are (1) supplier negotiations, (2) contract preparation,
and (3) purchase order processing. Costs are to be allocated to each activity on the basis of the
following cost drivers.

Quantity for
Activity Cost Driver Cost Rate Main Product
1 Number of types
of materials $12 per type 12 types
2 Number of units $0.14 per unit 17,500 units
3 Number of orders $77 per order 30 orders

The monthly purchasing cost assigned to the main product using ABC is:

a. $4,096
b. $404 lower than using the traditional system
c. $4,500
d. $404 higher than using the traditional system
e. None of the above

2. (3 points) Activity-Based Costing tends to be most beneficial in firms with:

a. A high proportion of product costs relative to period costs
b. Many products that use different amounts of resources
c. Few products that use about the same amount of resources
d. Both A and C
e. None of the above

3. (4 points) Solar Salt Company has two divisions. Sales, direct materials cost, and direct labor
cost data for Solar Salt’s two divisions are not available. However, manufacturing overhead and
gross profit data for the two divisions are available, as follows.
Agricultural Retail
Products Products
Manufacturing overhead* $450,000 $250,000
Gross profit 150,000 100,000

*Manufacturing overhead is allocated to production based on the amount of direct labor cost.

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 Solar Salt has determined that its total manufacturing overhead cost of $700,000 is a mixture
of unit-level costs, batch-level costs, and product line costs. Solar Salt has assembled the
following information concerning the manufacturing overhead costs, the annual number of
units produced, production batches, and number of product lines in each division.
Total
Manufacturing
Overhead Agricultural Retail
Costs Products Products
Unit-level overhead $210,000 7,500 units 13,500 units
Batch-level overhead 280,000 50 batches 90 batches
Product line overhead 210,000 10 lines 18 lines
$700,000

How much will GROSS PROFIT for Agricultural Products division be if Solar Salt adopts
an activity-based costing system?
a. loss of $50,000
b. $50,000
c. $150,000
d. $350,000
e. none of the above

4. The Underpants Gnomes Inc. (UGI) has used a traditional cost accounting system to apply
overhead to its three product divisions using direct labor hours as an application base. UGI is
considering activity-based costing. At the beginning of the period, UGI had no inventory. The
following are actual costs during the year (excluding direct materials):

Activity Cost Driver Activity Level Actual Costs

Direct Labor Direct labor hours 1,000 $20,000
Materials Handling Orders 9,000 $36,000
Assembly Machine-hours 3,000 $24,000

Other information regarding UGIs three divisions, Gloves, Socks and Underpants is as follows:

Underpants Socks Gloves

Number of units produced 10,000 20,000 5,000
Number of units sold 10,000 20,000 4,000
Total Direct Materials ($) $10,000 $10,000 $10,000

Direct labor hours 300 300 400

Orders 2,500 500 6,000
Machine-hours 250 250 2,500

(1) (7 points) If UGI uses activity-based costing instead of using a traditional costing system
how much greater or less will the cost per unit for a Glove?

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(2) (3 points) How much indirect costs (in total) are allocated to the Underpants division using a
traditional costing system?

(3) (3 points) Assuming all else constant, what is the change in net income for the year if UGI
changes from a traditional costing system to an activity-based costing system?

(4) (3 points) Assuming all else constant, what is the change in net cash flow for the year if UGI
changes from a traditional costing system to an activity-based costing system?

5. Wilkindad Inc. has used a traditional cost accounting system to apply overhead to its three
product divisions using direct labor hours as an application base. Wilkindad is considering
activity-based costing, whereby materials handling costs are driven by number of orders and
assembly related costs are driven by machine hours. At the beginning of the period, Wilkindad
had no inventory. The following are actual indirect costs during the year:

Indirect cost pools Actual Costs

Materials Handling $36,000
Assembly $24,000
Total Indirect Costs $60,000

Information regarding Wilkindad’s 3 divisions, Pumps, Valves and Flows is as follows:

Pumps Valves Flows

Total Direct Materials ($) $8,000 $16,000 $6,000
Total Direct Labour ($) $6,000 $6,000 $8,000
Number of units produced 10,000 20,000 5,000
Number of units sold 10,000 10,000 4,000

Direct labor hours 600 600 800

Orders 1,250 250 3,000
Machine-hours 750 250 2,000

(6 points) If Wilkindad uses activity-based costing instead of using a traditional costing system
how much greater or less will the cost per unit for a Flow?

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Session 5 Decision making and relevant costs

1. (3 points) Examining the following division profitability report, which of the following
statements is TRUE?

Singapore Fontainebleau Beijing

Number of units 2,000 5,000 4,000
Cost per unit $88.20 $70.10 $45.50

a. If we eliminate Singapore we will save $176,400

b. If we eliminate Singapore we will save $167,400
c. If we double production of Beijing our costs will increase by $182,000
d. Both A and C
e. None of the above

2. (3 points) Boracay Products sells computer widgets for $40 a box; one box is considered one
unit. The widgets cost the company $10 a unit. Boracay Products is planning to rent a booth at the
upcoming Area Computer Show. The company has two options for paying for the booth at the
show: 1) paying a fixed fee of $3,000; or 2) paying a $1,000 fee plus 10% of her sales revenues at
the show.

At what sales level would the company be indifferent between using option 1 and option 2 to pay
for the booth?

a. 666.67 units
b. 500 units
c. 400 units
d. 300 units
e. None of the above

3. (3 points) Examining the following customer profitability report, which of the following
statements is TRUE?
Ashley Bernardo Christoph Daniella
Revenues $20,000 $10,000 $5,000 $15,000
Cost of goods sold $15,000 $6,000 $3,000 $10,000
Indirect customer support costs $3,000 $4,000 $3,000 $4,000

a. If we eliminate Ashley our profit will increase

b. If we eliminate Bernardo our profit will increase
c. If we eliminate Christoph our profit will increase
d. If we eliminate Daniella our profit will increase
e. Cannot determine if any of the above statements are true from the data provided

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4. (4 points) International Toilettes (IT) is a wholesaler that imports toilets from SE Asia and
exports them to French speaking countries. IT has no inventory as it orders from manufacturers
only after receiving an order from a customer. Below is a customer profitability report for four
IT customers:
Hugo Louis Chloe Enzo
Revenues $20,000 $10,000 $5,000 $15,000
Cost of goods sold $15,000 $6,000 $3,500 $9,500
Allocated customer support costs $3,000 $5,500 $1,000 $4,000
Customer profitability $2,000 ($1,500) $500 $1,500

A special study was done on IT’s customer support costs, which determined that IT’s customer
support costs would decrease by $2,000 for each customer it no longer supplied. Assuming
customer behaviour will remain similar, which of the following statements is TRUE?

a. If we eliminate Louis our profit will increase

b. If we eliminate Chloe our profit will increase (-5000 + 3500 + 2000 = 500)
c. If we eliminate Enzo our profit will increase
d. If we eliminate Louis and Chloe our profit will increase
e. Cannot determine if any of the above statements are true from the data provided

5. (3 points) Which submitted MA case demonstrated the cost allocation death spiral?
a. Wilkerson Company
b. Bridgeton Industries
c. Munchen Industrielle Bauteile
d. Barrows Consumer Products
e. Citibank

6. (3 points) Hanoi Racks (HR) is a wholesaler that imports wine racks from SE Asia and exports
them to Spanish speaking countries. HR has no inventory as it orders from manufacturers only
after receiving an order from a customer. Below is a customer profitability report for four HR
customers:
Sofia Isabella Alejandro Matias
Revenues $10,000 $5,000 $8,000 $20,000
Cost of goods sold $6,000 $4,000 $6,500 $15,000
Allocated customer support costs $5,500 $1,000 $1,000 $3,000
Customer profitability ($1,500) $0 $500 $2,000

A special study was done on HR’s customer support costs, which determined that HR’s customer
support costs would decrease by $1,400 for each customer it no longer supplied. Assuming
customer behaviour will remain similar, which of the following statements is TRUE?

a. If we eliminate Sofia our profit will increase

b. If we eliminate Isabella our profit will increase
c. If we eliminate Alejandro our profit will increase

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d. If we eliminate Sofia and Isabella our profit will increase
e. If we eliminate Sofia and Isabella and Alejandro our profit will increase

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Session 6&7 Strategic decision making and Capital budgeting

1. (3 points) Which of the following statements is TRUE?

a. Firms must use a depreciation method based on time (e.g., years) for managerial
accounting purposes
b. Firms must use a depreciation method based on time for financial reporting purposes
c. Firms must use the same depreciation method for tax accounting and financial
reporting purposes
d. Firms can use whatever depreciation method they like for tax accounting purposes
e. All statements are false

2. (3 points) For a firm that is financed 100% with equity, which of the following statements is
true regarding an increase in the firm’s net working capital (all else equal)?
a. Net income will decrease and firm value will increase
b. Net income will increase and firm value will decrease
c. Net income will increase and firm value will increase
d. Net income will be the same and firm value will decrease
e. Net income will be the same and firm value will increase

3. Bo Inc. manufactures and sells widgets. The cost per unit of a widget is $9, which includes $2
per unit of fixed overhead based on Bo producing and selling 100,000 widgets per year. Widgets
sell for $12 per unit. Bo Inc.’s tax rate is 40%.

(1) (3 points) What is the sales (in units) to achieve a before-tax annual target profit of $100,000?

(2) (3 points) What is the revenue (in dollars) to achieve an after-tax annual target profit of
$120,000?

(3) (8 points) Bo Inc. is considering offering credit to widget customers. The pricing director has
determined that if Bo offers free credit to widget customers on 30 day payment terms that Bo
will sell 6,000 units more per year at the current unit price of $12. It is expected between the
widget’s new and expected existing customers that 60,000 units will be purchased on Bo Inc.’s
new credit terms. Bo Inc.’s cost of capital after tax is 10% and Bo Inc.’s tax rate is (still) 40%.

What is the NPV of the decision to offer credit to customers assuming that the decision to
offer credit will only be for two years? (Please assume no other costs/benefits other than
those explicitly mentioned).

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4. Abu-Dubai Ltd. is considering replacing its old plastic refining machine with a new carbon-
fiber machine on January 1. Information regarding the two machines is presented below:

Old Plastic Machine New Carbon-Fiber Machine

Purchase price €80,000 (5 years ago) €390,000
Current net book value €40,000 -
Current disposal value €6,500 N/A
Remaining life of asset 5 years 5 years
Disposal value in five years 0 0
Working capital required €6,000 €15,000
Current age of machine 5 years

The before-tax additional operating cash inflows from the carbon-fiber machine are €120,000 in
years 1 through 5. Assume Abu-Dubai Ltd. uses straight-line depreciation for financial reporting.
The opportunity cost of capital for this project is 8%.

(1) (8 Points) Assuming Abu-Dubai Ltd pays no income tax, what is the NPV for replacing the
old machine with the new machine?

(2) (6 Points) Assume the CEO of Abu-Dubai Ltd is being incentivized solely on the basis of net
income. What is the change in net income for Abu-Dubai Ltd in the first year if the old machine
is replaced with the new machine?

(3) (8 Points) Assume the same facts above regarding the two machines except Abu-Dubai Ltd is
now subject to an income tax rate of 40%. Also assume: 1) financial and tax deprecation are both
based on straight-line depreciation; 2) capital gains tax rates are also taxed at 40%; 3) tax effects
and cash-flows occur at the same time as the cash flows; 4) Abu-Dubai Ltd is currently very
profitable. What is the NPV for replacing the old machine with the new machine assuming Abu-
Dubai Ltd is subject to income taxes?

5. Women In Mauve Ltd. (WIM) drills small commercial water wells. On January 1, the
company is in the process of analyzing the purchase of a new drill for $200,000. The new drill
will save $48,000 per year compared to the existing drill, and has an expected life of four years.
The existing drill was purchased for $100,000 one year earlier, has an expected remaining life of

20
four years, and can be sold today for $60,000. The new drill has an expected salvage value of
$40,000 in four years’ time, while the old drill has no expected salvage value in four years’ time.

Government regulation requires straight-line depreciation with NO residual/salvage value for

both financial and tax purposes. (The tax authorities have deemed the new and old drill must
have 4 and 5 years expected life at purchase, respectively).

The opportunity cost of capital for the project is 10%. (Hint: do not even think about using a
WACC here).

(1) (8 Points) Assuming Women In Mauve Ltd. is NOT required to pay any income taxes, what
is the NPV for replacing the old drill with the new drill?

(2) (6 Points) What is the change in net income for Women In Mauve Ltd. in the first year if the
old drill is replaced with the new drill?

(3) (6 Points) Assume the same facts above regarding the two drills except Women In Mauve
Ltd. is now subject to an income tax rate of 40%. Also assume: 1) capital gains tax rates are also
taxed at 40%; 2) tax effects and cash-flows occur at the same time as the cash flows; 3) Women
In Mauve Ltd. is currently very profitable. What is the NPV for replacing the old drill with the
new drill assuming Women In Mauve Ltd. is subject to income taxes?

6. GRABTAXI is considering replacing an old machine with a new machine. (GRABTAXI has
some operational issues to address too, as you will see this afternoon). The information regarding
the two machines is below:

Old Machine New Machine

Purchase price $200,000 (2 years ago) $400,000
Current disposal value $40,000 -
Disposal value in three years $10,000 $100,000
Annual pre-tax operational cost savings - $90,000
Current age of machine 2 years

Both machines must be straight-line depreciated with NO residual value over a five year period
for tax and financial accounting purposes. All operational cost savings are cash-related.
GRABTAXI’s opportunity cost of capital is 12% and GRABTAXI’s tax rate for income is 30%
and for capital gains/losses is 40%.

21
(1) (6 points) What is the initial incremental net cash (at t=0) required to finance the replacement
of the old machine with the new machine? (Assume all tax effects and cash flow effects occur at
the same time as the cash flows).

(2) (5 points) How much higher or lower is the reported net profit after-tax in Year 2 if
GRABTAXI replaces the old machine with the new machine?

(3) (5 points) Assume the same facts above, except GRABTAXI has tax free status (is a non-
taxable entity) due to an incentive offered by the local government. What is the NPV for
replacing the old machine with the new machine over the first three years of the transaction
assuming the new machine is sold in three years’ time and GRABTAXI does not pay any taxes?

7. (6 points) The Mandarin Foundation has computed the net present value of a machine to be a
positive $10,000. Mandarin uses a discount rate of 12%. However, the Mandarin Foundation
forgot to consider the fact that the use of the machine will require working capital of $40,000 to
be tied up for the entire 4-year life of the machine. The Mandarin Foundation also forgot that the
additional working capital would result in incremental annual variable costs of $1,000 per
annum. After considering the impact of this working capital requirement, what is the net
present value of the machine? Ignore income taxes as the Mandarin Foundation is a not-for-
profit.

NPV $ .

8. (6 Points) The Purple Line Yard (PLY) is considering buying a car smasher. The car smasher
would add net before-tax cash flows of €80,000 at the end of the first year and the end of the
second year (it will only last two years). The initial cost of the car smasher is €100,000. At the
end of two years, the salvage value of the car smasher is estimated to be $0. The required rate of
return on the car smasher is 10%. The income tax rate is 40%. PLY uses straight-line
depreciation (for the car smasher’s 2-year life) for income tax purposes. Income taxes are paid at
the end of the year. What is the net present value of the car smasher machine?

NPV € .

22
9. (6 Points) The Purple Line Yard Again (PLYA) purchased a car smasher on January 1, 2013.
The car smasher added net before-tax cash flows of €80,000 at the end of both 2013 and 2014 (it
will only last two years). The initial cost of the car smasher was €100,000. At the time of
purchase, the salvage value of the car smasher is estimated to be $0. The required rate of return
on the car smasher is 10%. The income tax rate is 40%. PLYA used straight-line depreciation
(for the car smasher’s 2-year life) for income tax purposes. Income taxes are paid at the end of
each calendar year. On December 31, 2014, the PLYA sold the car smasher for €25,000.

How much higher or lower is the reported net profit after-tax in 2014 as a result of PLYA
purchasing the car smasher in 2013 and selling it at the end of 2014?

€ .

10. (6 points) Rewarding Revision Inc. (RRI) manufactures and sells widgets. The cost per unit
of a widget is $9, which includes $2 per unit of fixed overhead based on Bo producing and
selling 100,000 widgets per year. Widgets sell for $12 per unit.

RRI is considering offering credit to widget customers. The pricing director has determined that
if RRI offers free credit to widget customers on 30 day payment terms that RRI will sell 6,000
units more per year at the current unit price of $12. It is expected between the widget’s new and
expected existing customers that 60,000 units will be purchased on RRI’s new credit terms.
RRI’s cost of capital after tax is 10% and tax rate is 0%.

(1) What is the NPV of the decision to offer credit to customers assuming that the decision to
offer credit will only be for one year? (Please assume no other costs/benefits other than those
explicitly mentioned).
NPV $ _______ .

(2) (2 points) Same facts as above except the tax rate is 40%. What is the NPV of the decision to
offer credit to customers assuming that the decision to offer credit will only be for one year?
(Please assume no other costs/benefits other than those explicitly mentioned).
NPV $ ______ .

23
11. REPEATTAXI is considering replacing an old machine with a new machine. The
information regarding the two machines is below:

Old Machine New Machine

Purchase price $200,000 (2 years ago) $600,000
Current disposal value $50,000 -
Estimated disposal value in three years $0 $400,000
Current age of machine 2 years
Annual pre-tax operational cost savings - $110,000

Both machines must be straight-line depreciated with NO residual (salvage) value over a five
year period for tax and financial accounting purposes. REPEATTAXI’s opportunity cost of
capital is 10% and REPEATTAXI’s tax rate is 40%.

(1) (6 points) What is the initial incremental net cash (at t=0) required to finance the replacement
of the old machine with the new machine? (Assume all tax effects and cash flow effects occur at
the same time as the cash flows).
$_______________

(2) (6 points) How much higher or lower is the reported net profit after-tax in Year 2 if
REPEATTAXI replaces the old machine with the new machine?
$_______________

(3) (6 points) Assume the same facts above, except REPEATTAXI has tax free status (is a non-
taxable entity) due to an incentive offered by the local government. What is the NPV for
replacing the old machine with the new machine over the first three years of the transaction
assuming the new drill is sold in three years’ time and REPEATTAXI does NOT pay taxes?

$_______________

(4) (6 points) Assume the same facts above, except REPEATTAXI does pay taxes at 40% for
both net income and capital gains and losses. What is the NPV for replacing the old machine
with the new machine over the first three years of the transaction assuming the new drill is sold
in three years’ time and REPEATTAXI DOES pay taxes? (Assume all tax effects and cash flow
effects occur at the same time as the cash flows).

$_____________

24
Session 8 Introduction to agency; Transfer pricing

1. (3 points) Which item is NOT a transfer pricing red flag for tax authorities?

a. lack of sufficient documentation

b. different deprecation rates for tax and financial accounting purposes
c. significant inter-company management fees
d. royalties charged for soft intangibles
e. all the above are transfer pricing red flags for tax authorities

2. (3 points) Which of the statements below is TRUE?

a. an advantage of negotiated transfer pricing is that it can be done with little time or
effort
b. variable-cost transfer prices avoid incentives for selling divisions to misclassify costs
c. an advantage of using budgeted costs for transfer prices is seller inefficiencies are not
passed along to the buying division
d. making adjustments to inter-company prices at the end of the year will reduce tax
authority suspicion
e. optimal decisions will result when goods or services are transferred at full-cost prices

3. (3 points) Which statement about transfer pricing is FALSE?

a. If the selling division is operating below capacity the marginal cost is an appropriate
transfer price
b. If the selling division is operating at capacity the market price is an appropriate
transfer price
c. If an intermediate product will be sold between two divisions in the same legal and
tax jurisdiction regardless of the transfer price, for the firm overall the transfer price
is irrelevant
d. “Double Dutch with an Irish Sandwich” is a transfer pricing tax minimization
strategy that was developed in the last decade
e. Documentation of the process how transfer prices are determined helps reduce
transfer pricing risk

4. (3 points) Cambodia Palms has a Raw Palm Division and a Finished Palm Division. Raw palm
can be sold at $200 per 100 board-metres. Finished palm can be sold at $275 per 100 board-
metres. The Raw Palm division is currently running at capacity. The variable costs for the two
divisions are:
- Raw Palm Division: $100 per 100 board-metres of raw palm.
- Finished Palm Division: $125 per 100 metres of finished palm.

25
Which of the following statements are TRUE?
a. Cambodia Palms SHOULD process the raw palms into finished form and a transfer
price made at 110% of variable costs the Raw Palm Division WILL prefer the transfer to
the Finished Palm division.
b. Cambodia Palms SHOULD NOT process the raw palms into finished form and a
transfer price made at 110% of variable costs the Raw Palm Division WILL prefer the
transfer to the Finished Palm division.
c. Cambodia Palms SHOULD process the raw palms into finished form and a transfer
price made at 110% of variable costs the Raw Palm Division WILL NOT prefer the
transfer to the Finished Palm division.
d. Cambodia Palms SHOULD NOT process the raw palms into finished form and a
transfer price made at 110% of variable costs the Raw Palm Division WILL NOT prefer
the transfer to the Finished Palm division.
e. Cannot determine if any of the above statements are true from the data provided.

5. (4 points) Philippines Nuts has a Raw Nuts Division and a Coco-Nuts Division. Coco-Nuts
Division takes Raw Nuts to further process them into Coco-Nuts. Raw Nuts can be sold
externally at $38 per 100kg. Coco-Nuts nuts can be sold externally at $55 per 100kg. The Raw
Nuts division is currently running substantially below capacity. The variable costs for the two
divisions are:
- Raw Nuts Division: $22 per 100kg of Raw Nuts.
- Coco-Nuts Division: $25 per 100kg of Coco-Nuts.

Which of the following statements are TRUE?

a. Philippines Nuts SHOULD process the raw nuts into Coco-Nuts and a transfer price
made at 150% of variable costs the Coco-Nuts Division WILL prefer the transfer from the
Raw Nuts division.
b. Philippines Nuts SHOULD NOT process the raw nuts into Coco-Nuts and a transfer
price made at 150% of variable costs the Coco-Nuts Division WILL prefer the transfer
from the Raw Nuts division.
c. Philippines Nuts SHOULD process the raw nuts into Coco-Nuts and a transfer price
made at 150% of variable costs the Coco-Nuts Division WILL NOT prefer the transfer
from the Raw Nuts division. (55 – 22 – 25 = 8; 55 – 33 – 25 = -3)
d. Philippines Nuts SHOULD NOT process the raw nuts into Coco-Nuts and a transfer
price made at 150% of variable costs the Coco-Nuts Division WILL NOT prefer the
transfer from the Raw Nuts division.
e. Cannot determine if any of the above statements are true from the data provided.

6. (3 points) AutoTech's Northern Division is currently purchasing a part from an outside supplier.
The company's Southern Division, which has no excess capacity, makes and sells this part for
external customers at a variable cost of $19 and a selling price of $31. If Southern begins sales to
Northern, it (1) will use the general transfer-pricing rule and (2) will be able to reduce variable cost

26
on internal transfers by $3. On the basis of this information, Southern would establish a transfer
price of:
a. $16
b. $19
c. $28
d. $31
e. Some other amount

7. (3 points) Which of the following statements is FALSE regarding negotiated transfer prices?
a. they work only if both managers have some bargaining power
b. they assist firms in minimizing their overall corporate taxes
c. they are costly in management time
d. they accentuate conflicts between managers
e. they allow divisions to consider their opportunity costs

8. (4 points) The Woofer Corporation produces and sells the DOGmobile, a remote controlled
toy car. The DOGmobile sells at a price of $20. Woofer’s current production capacity of 10,000
units.

Woofer’s operating costs are given below:

Direct materials $2 per unit
Direct manufacturing labor $3 per unit
Shipping $4 per unit
Manufacturing overhead
Variable $2 per unit
Fixed $30,000

Lauren Ltd. has asked Woofer to produce 2,000 units of the CATmobile, a modification of the
DOGmobile. The CATmobile would require the same manufacturing processes as the
DOGmobile. Lauren Ltd. would arrange and pay for the shipping themselves. Due to their cost
structure, Lauren Ltd. will only accept the deal if all 2,000 units are produced.

If Woofer were presently producing and selling 9,000 units, what is minimum price per unit
Woofer would accept to sell 2,000 units to Lauren Ltd.?
a. less than $7.50
b. between $7.50 and $8.99
c. between $9.00 and $10.49
d. between $10.50 and $12.00
e. greater than $12.00

9. (4 points) Assume the same facts as above, except that current customer demand for
DOGmobiles is 12,000 units, which exceeds current capacity of 10,000 units. Lauren Ltd. has
offered to purchase a total of 2,000 CATmobiles at a price of $15.50 per unit. Facilities-for-Rent

27
Company has offered to rent Woofer as much additional production space as it wishes at the rate
of $8.75 per unit. Which alternative below should Woofer accept?
a. Sell only 10,000 DOGmobiles to current customers
b. Sell 12,000 DOGmobiles to current customers
c. Sell 10,000 DOGmobiles to current customers and 2,000 CATmobiles to Lauren Ltd
d. Sell 12,000 DOGmobiles to current customers and 2,000 CATmobiles to Lauren Ltd
e. Sell 8.000 DOGmobiles to current customers and 2,000 CATmobiles to Lauren Ltd

10. Cabaret Corporation has several operating divisions that are run as profit centers. The
Acoustics Division manufactures and sells speakers. Its expected production is 80,000 speakers.
Each speaker requires a single woofer, which Cabaret currently purchases from an outside
supplier at $80 per unit.

The Components Division of Cabaret manufactures and sells 35,000 woofers to outside
customers at a unit price of $120. THIS OUTSIDE DEMAND IS EXPECTED TO REMAIN
THE SAME INTO THE FORESEEABLE FUTURE. The Components Division has the capacity
to make 50,000 woofers. It has unit variable manufacturing costs of $45 and unit variable
marketing costs of $4 per woofer. Its fixed manufacturing costs are $500,000. The Components
Division would not incur any variable marketing costs if it supplies woofers internally to the
Acoustics Division.

(1) (5 points) The Acoustics Division proposes to buy 20,000 woofers from the Components
Division at a total price of $1,200,000. Assume that this is a take-or-leave-it proposal, that
is, the Acoustics Division wishes to buy 20,000 and no less than 20,000 woofers. How
much better-off or worse-off will the Components Division be if they accept this proposal?

(2) (5 points) Suppose instead that the Acoustics Division proposes to buy 10,000 woofers
from the Components Division. For what range of per-woofer transfer prices will the
managers of the Components Division and the Acoustics Division acting in their own
interests (i.e., maximizing their own profits) agree to this transfer? (Hint: Consider the
range of transfer prices that will induce the Acoustics Division to buy the 10,000 woofers
and the Components Division to supply the 10,000 woofers.)

(3) (5 points) Recall that the Components Division’s capacity is 50,000 units. In order to
maximize firm profits, how many of the 50,000 woofers should be sold to:

28
 (a) outsiders
(b) the Acoustics Division?
Total

11. Constance S.A. makes all types of office desks. The Computer Desk Division is currently
producing 10,000 desks per year with a capacity of 20,000. The variable cost for each desk is
€300 and annual fixed costs of the division are €900,000. The computer desk sells for €400.

The Executive Division wants to buy 5,000 desks at €280 for its custom office design business.
Should the order be accepted, the Executive Division plans on selling the desks to the outside
market for €390 after incurring additional costs of €50 per desk.

The accounting intern in the Computer Desk division provides the following summary of the
deal.

Computer desk Currently Including new deal

Units produced and sold (desks) 10,000 15,000
Variable costs per unit €300 €300
Fixed costs per unit €90 €60

(1) (4 points) How much better-off or worse-off will the Computer Desk Division be if the order
is accepted?

(2) (4 points) How much better-off or worse-off is Constance S.A. if the order takes place?

(3) (4 points) If the Computer Desk Division and the Executive Division have permission to
negotiate a transfer price between them, is there a range of prices where the deal with take place?
And if so, what range?

29
Session 9 Budgeting and variances

1. (3 points) Palm Inc. has the following information regarding their budgeted and actual
performance.

Master Budget Actual

Units 1,500 units 1,100 units
Direct labour hours (total) 3,000 hours 1,650 hours
Direct labour cost per hour $20 $22

What is the flexible budget variance for direct labour?

a. More than $5,000 unfavourable
b. Between $5,000 and $1 unfavourable
c. There is no flexible budget variance
d. Between $1 and $5,000 favourable
e. More than $5,000 favourable

2. (4 points) Bombay Chole Ltd. has the following information regarding their budgeted and
actual materials cost:
Actual Master Budget
Direct material (total) 4,000 kg 3,000 kg
Direct material cost per kg $8.8 $9.6

Bombay Chole Ltd. budgeted to produce 1,200 bags of chole, but actually produced 1,400 bags.

What is the flexible budget variance for direct material?

a. More than $2,000 unfavourable
b. Between $2,000 and $1 unfavourable
c. There is no flexible budget variance
d. Between $1 and $2,000 favourable
e. More than $2,000 favourable

3. (3 points) Rewarding Revision Manufacturing Company produces two products for which the
following data have been tabulated. Fixed manufacturing cost is allocated at a rate of $2.00 per
machine hour.

Per unit: Product A Product B

Selling price $5.00 $3.50
Variable manufacturing cost $2.00 $1.50
Fixed manufacturing cost $1.00 $0.50
Variable SG&A cost $0.40 $1.00

30
The sales manager has had a $40,000 increase in the budget allotment for advertising and wants
to apply the money to the most profitable product. The products are not substitutes for one
another in the eyes of the company's customers.

Rewarding Revision has only 10,000 machine hours that can be made available to produce
additional units of products A and B. If the potential increase in sales units for either product that
results from the advertising is far in excess of this production capacity, which product should be
advertised and what is the estimated increase in total contribution margin?

a. Product A, yielding a contribution margin between $0 and $50,000

b. Product A, yielding a contribution margin greater than $50,000
c. Product B, yielding a contribution margin between $0 and $50,000
d. Product B, yielding a contribution margin greater than $50,000
e. None of the above

4. (3 points) Assume you planned produce 1,500 units, where you planned to use 4 hours of
direct labour per unit produced and the budgeted cost of labour was $20 per hour. The total
actual direct labour costs were $84,700 based on an actual production of 1,100 units. What is the
flexible budget variance for labour?
a. More than $5,000 unfavourable
b. Between $1 and $5,000 unfavourable
c. No flexible budget variance
d. Between $1 and $5,000 favourable
e. More than $5,000 favourable

5. The following information pertains to March 2014 for the Barbizon creperie, “La Bonne
Crêpe”. Assume all variable costs relate to crepe ingredient and making costs. La Bonne Crêpe
has a cost of capital of 10%.

Master Budget Actual Results

Sales volume (in crepes) 25,000 20,000

Sales revenue €125,000 €100,000

Variable costs €60,000 €51,200
Fixed costs €45,000 €45,800
Operating profit €20,000 €3,000

(1) (5 points) The owner is trying to evaluate the performance of the production manager (“The
chef”). What is the flexible budget variance related to total costs?

31
(2) (4 points) If La Bonne Crêpe increased annual production and sales of crepes to 75,000
crepes from 25,000 for one month, based on the budgeted information provided above how much
would its profit increase or decrease for the month?

(3) (4 points) La Bonne Crêpe pays its entire crepe ingredient and making costs one month after
using them, and customers can only pay with cash. La Bonne Crêpe has no inventories. If La
Bonne Crêpe increased monthly production and sales of crepes to 75,000 crepes, based on the
budgeted information provided above, how much would net working capital increase or
decrease?

32
Session 10 Financial performance evaluation

1. (3 points) What statement regarding ROI is FALSE?

a. Due to deprecation, projects over time will have increasing ROI

b. ROI encourages better performing managers to underinvest
c. ROI encourages poorer performing managers to overinvest
d. An increase in a division’s ROI, all things equal, will result in an increase in firm
value
e. All the above statements are true

2. (3 points) Napoleon S.A. has two divisions. Each division’s required rate of return is 8%.
Planned operating results for 2015 are as follows.
Division Income Investment
Alba 25,000,000 50,000,000
Fontainebleau 25,000,000 150,000,000

Napoleon S.A. is planning an expansion, which will require each division to increase its
investments by $25,000,000 and its income by $3,000,000. Assuming managers are
evaluated solely on residual income, which divisions are pleased with the expansion?

a. Only Alba
b. Only Fontainebleau
c. Both Alba and Fontainebleau
d. Neither Alba nor Fontainebleau
e. Insufficient information to determine

3. (3 points) Which of the statements is TRUE regarding the expected performance of a firm in a
perfectly competitive market?

a. the firm’s expected profit is zero

b. the firm’s expected residual income is zero
c. the expected value of the firm’s future cash flows is zero
d. the firm’s expected return on assets is zero
e. the firm’s expected return on invested capital is zero

4. (3 points) Which of the following performance measures when used to evaluate and reward
managers encourages poorly performing managers to overinvest?

a. net income
b. return on investment
c. residual income

33
 d. economic valued added
e. none of the above measures encourages poorly performing managers to overinvest

5. (3 points) Which of the following performance measures overcomes the horizon problem?

a. net income
b. return on investment
c. residual income
d. cash flows from operation
e. none of the above measures overcomes the horizon problem

6. (3 points) Constance S.A. has two divisions. Each division’s required rate of return is 10%.
Planned incomplete operating results for 2016 are as follows.
Division Income Investment
Singapore 50,000,000 100,000,000
Fontainebleau ??? 50,000,000

Constance S.A. is planning an expansion, which will require each division to increase its
investments by $25,000,000 and its income by $2,000,000. Assuming managers are
evaluated solely on residual income, which divisions are pleased with the expansion?
a. Only Singapore
b. Only Fontainebleau
c. Both Singapore and Fontainebleau
d. Neither Singapore nor Fontainebleau
e. Insufficient information to determine

7. (3 points) You need to evaluate the financial performance of your division managers for a
multinational firm. Each division manager is responsible for a different Southeast Asian country.
There is substantial information asymmetry between you and your managers as it is prohibitive and
costly to obtain objective market information. Which performance benchmark should be used to
assess manager performance?
a. past financial performance of the division
b. the financial performance of your other division managers in Southeast Asia
c. bottom-up budget-based financial performance targets
d. the financial performance of competitors in the same country for each division
e. A and B are both appropriate benchmarks

8. (3 points) Which of the following statements is TRUE regarding the use of Economic Value
Added®, a modified accounting measure related to residual income advocated by Stern Stewart
and other consulting firms?
a. EVA® is easily understood for employee incentive purposes
b. EVA® overcomes the arbitrary accounting choices that exist in GAAP/IFRS

34
 c. EVA® removes the need to maintain GAAP/IFRS accounting numbers
d. EVA® is solely focused on adjusting net income to provide a better measure of
financial performance
e. none of the above statements are true

9. The Underpants Gnomes Inc. had the following financial information for their South-East
Asian operations:

Income Statement 2012 Schedule of Advertising

(according to IFRS) Expenditures

Revenue $9,500 Year Amount

Cost of sales 4,200 2009 1,200
Allocated corporate overhead 228 2010 1,600
Local advertising 3,000 2011 2,400
Other general and admin 392 2012 3,000
Net income $1,680

Total assets (according to IFRS) at the beginning of 2012 was $5,000. There were no current
liabilities. The cost of capital for the Underpants Gnomes South-Eat Asian operations is 10%.
While advertising is treated as a period cost under IFRS, Underpants Gnomes believes that
advertising expenditures have an economic expected life of 2 years. (e.g. $1 spent in 2010, will
have 50% benefit in 2010 and 50% benefit in 2011), determine the residual income according
to IFRS rules for their South-East Asian operations. (Ignore taxes).

10. Super Supermarkets (SS) wants to evaluate the performance of their three main operating
divisions: Soft Drinks, Fresh Produce and Packaged Food. SS has an opportunity cost of capital
of 10%. SS has the following data for their three divisions:

Soft Drinks Fresh Produce Packaged Food TOTAL

Revenues $800,000 $1,200,000 $2,000,000 $4,000,000
COGS $500,000 $1,000,000 $1,000,000 $2,500,000
No. of purchase orders 100 210 190 500
Hours of stocking time 20 50 55 125
Items sold 10,000 14,500 15,500 40,000
Assets $200,000 $100,000 $200,000 $500,000

The total indirect costs associated with running SS is presented below:

Ordering $100,000
Stocking $100,000
Customer support $120,000

35
Total indirect costs $320,000

(1) (5 points) Assuming SS allocates indirect costs on the basis of COGS, what is the residual
income of the Soft Drinks division?

(2) (5 points) Assuming SS is considering using ABC to allocate indirect costs, with ordering
costs driven by number of purchase orders, stocking costs driven by hours of stocking time, and
customer support driven by items sold, what would be the ROA for the Soft Drinks division
using an ABC approach?

(3) (5 points) Considering the costs and benefits for SS, would you recommend SS replace their
current costing system with the proposed ABC approach? (Please answer yes or no on the
answer page, and write your reasoning below in 30 words or less).

11. Bell Enterprises has three operating divisions. The managers of each of the divisions are
evaluated and compensated based on the operating income earned by their divisions. Divisional
operating income includes an allocation of fixed corporate overhead costs proportional to the
revenues earned by the division. The income statements based on IFRS for the divisions and for
the firm (in thousands) for 2014 are as follows:

(in thousands) Kim Division Lee Division Zhou Division TOTAL

Revenues $2,000 $1,200 $1,600 $4,800
Cost of goods sold 1,050 540 640 2,230
Gross margin 950 660 960 2,570
Division overhead 250 125 160 535
Corporate overhead 400 240 320 960
Operating income 300 295 480 1,075

The manager of Kim division is evaluating a proposal to eliminate one of the division’s product
lines. The data below describe the effects of that product line on the division’s operating income:
Revenues $800,000
Cost of goods sold $600,000
Avoidable division overhead $100,000

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(1) (3 points) How much better off or worse off would Kim Division be if the product line is
discontinued? (Show the effect on the division’s operating income.)

(2) (3 points) How much better off or worse off would Bell Enterprises be if the product line is
discontinued? (Show the effect on the firm’s operating income.)

(3) (3 points) Indicate one way Bell Enterprises could change how it determines divisional
operating income that would motivate its managers to make decisions that would be optimal for
the firm, as a whole. (Answer MUST be in 10 words or less).

(4) (3 points) Bell Enterprises is considering using EVA® as prescribed in the EVA popularized
by Stern Stewart to evaluate its overall performance and the performance of its divisions. What is
NOT a likely outcome from Bell Enterprises replacing operating income with EVA® to evaluate
the overall performance and of its divisions?
a. better performing divisions will be more likely to underinvest
b. increased payouts to shareholders through share repurchases
c. increased disposals of under-utilized assets
d. managers will have a stronger preference for operating leases rather than capital
leases
e. Both A and D

(5) (6 points) Bell Enterprises will determine division EVA® starting with IFRS Operating
income (from the table above) then making adjustments as prescribed by Stern Stewart. One
adjustment is the treatment of employee training costs, which is expensed under IFRS but Bell
Enterprises believes should be amortized over two years, 50% in the year incurred and 50% in
the next year. Zhou Division had $100,000 of employee training costs in 2013, $120,000 in
2014, and is expected to have $140,000 employee training costs in 2015. Based on IFRS, Zhou
Division has total assets of $4 million (noting the previous table is in thousands). Zhou Division
has a cost of capital of 12%. Assuming no other facts, what is the EVA® for Zhou Division in
2014?

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(6) (2 points) Provide a key benefit from using a modified financial performance measure, like
the EVA calculated above. (Please provide one very short summary answers on the answer page,
and write your reasoning below in 5 words or less).

(7) (2 points) Provide a key problem or issue from using a modified financial performance
measure, like the EVA calculated above. (Please provide one very short summary answers on the
answer page, and write your reasoning below in 5 words or less).

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Session 11 Non-financial performance evaluation

1. (3 points) Based on your understanding of the balanced scorecard, should all companies reward
CEOs on customer satisfaction?

a. no
b. yes
c. I don’t know what customer satisfaction is
d. I don’t know what the balanced scorecard is
e. I don’t know what a company is

2. (3 points) Based on lecture and the readings “Coming Up Short on Nonfinancial Performance
Measurement” what is NOT a common mistake firms make when trying to measure nonfinancial
performance
a. Not including measures related to learning and growth
b. Not linking measures to strategy
c. Not validating the links
d. Measuring incorrectly
e. Not including objective performance measures

3. Subjective performance measures are used by firms to provide incentives to agents and
evaluate agent performance.

(1) (4 points) Provide two key benefits obtained from using subjective performance measures.
(Please provide two very short summary answers on the answer page, and write your reasoning
below in 30 words or less).

(2) (3 points) Provide a key problem or issue from using subjective performance measures or
subjective performance evaluation. (Please provide a very short summary answer on the answer
page, and write your reasoning below in 30 words or less).

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Session 12 Incentive system issues and alternative approaches

1. (3 points) Holmstom and Milgrom (1990) and Baker (1992) describe multi-tasking, whereby
agents are incentivized on multiple specific performance measures. What is NOT an implication of
using multiple performance measures to incentivize agents?

a. agents being exposed to more compensation risk

b. additional costs from monitoring more performance measures
c. agents selecting the easiest performance measures to improve
d. agents ignoring unmeasured actions even when these actions are consistent with
maximizing firm value
e. all the above are implications from multi-tasking

2. (3 points) A CEO should rely more on explicit (ex-ante) contracted incentives to compensate a
division manager when?

a. it is easy for those outside the firm to observe the division manager’s performance
b. there are limited opportunities to be promoted
c. there are many local competitors
d. it is easy to transfer skills across firms (i.e., limited firm-specific human capital)
e. the division manager is younger

3. (3 points) What is an example of an input-based approach to controlling agency costs?

a. using balanced scorecard to incentivize agents

b. using budgeted targets for performance evaluation
c. using claw-backs or vested shares to compensate agents
d. using an employee referral hiring scheme
e. none of the above are input-based approaches to controlling agency costs

4. (3 points) Which of the following would NOT influence the strength of implicit incentives?

a. the opportunity for promotion within the firm

b. the closeness the agent is to retiring
c. the accuracy of budgeted targets used for performance evaluation
d. the ease of using acquired skills at other firms
e. the ability of competitor firms to observe the agent’s performance

5. (3 points) In regard to CEOs compensation, which statement is FALSE?

a. giving the CEO more stock options will encourage greater risk taking
b. the presence of a future CEO pension will encourage less risk taking
c. using a balanced scorecard to incentivize the CEO will reduce horizon problems

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 d. the use of equity stock that will vest after retirement will expose the CEO to less risk
e. the use of performance clawbacks will reduce horizon problems

6. (3 points) Which is NOT a benefit of decentralization within firms?

a. Heightened goal congruence
b. Greater responsiveness to customer and suppliers
c. Freeing up more top management time to focus on strategic issues
d. Assists in development of an experienced pool of management talent to fill higher-
level positions
e. Faster decision making due to shorter decision chain

7. (3 points) Which of the following approaches does NOT address the horizon problem for
senior managers?
a. The use of performance clawbacks in compensation
b. Using cash-based measures of performance
c. Using non-financial performance measures that predict future performance
d. Using compensation that vests in future years
e. None of the above

8. (3 points) W. L. Gore and Associates, the makers of Gore-Tex, reduce the agency costs related
to employee free-riding in groups by:
a. Profit sharing based on only global profits
b. Having tailored incentive plans for each employee
c. Having flexible teams where employees can choose whom to work with for any
project
d. Using external labour market pressures to provide incentives to employees
e. Offering explicit contractible promotion opportunities based on the employee’s
length of time at the firm

9. (3 points) What is an implication of rewarding agents explicitly on performance measures?

a. the performance measure will be less useful for decision making purposes
b. agents will focus less on things that promote organizational objectives that are not
explicitly rewarded
c. agents will have incentive to manipulate the performance measure even if their action
reduces firm value
d. all of the above
e. none of the above

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10. (3 points) Which of the following is an organizational example from class to encourage better
decision making processes based on data and evidence rather than sub-optimal approaches such as
relying on the “HiPPO”?
a. the use of a “refer a friend” hiring scheme (Timpson)
b. profit sharing based only on global profits (W.L. Gore)
c. the use of a “culture” interview conducted by HR specialists (Zappos)
d. the creation of the “associate product manager” position (Google)
e. the implementation of a balanced scorecard (Citibank)

11. (3 points) For which of the following agents would a principal need to rely more on explicit
incentives to motivate effort?
a. an intern at a consulting firm
b. a CEO of the largest company in the industry sector
c. a college football head coach of a small university
d. an untenured research professor
e. the relative importance of explicit incentives for these above employees would be
similar

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12. (4 points) Beyond the actual compensation provided to employees, provide two key costs to
using explicit pay-for-performance to provide incentives to employees. (Please provide each cost
in 10 words or less).

13. (6 points) Given the potential “side effects” or externalities from using explicit pay-for-
performance provide three potential alternatives as discussed in class that organisations can use
to reduce agency costs without using explicit pay-for-performance. (Please provide each
alternative in 10 words or less).

14. (3 points) Explain the economic logic why some firms do not use any ex-ante (before the
event) contracts to incentivize CEOs, but alternatively say “we’ll work it out at the end”. Briefly
explain in 20 words or less.

15. (2 points) Explain a key disadvantage from lengthening the performance measurement
period. Explain in 10 words or less.

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FINANCIAL TABLES

Present Value of $1.00

S
P= .
(1 + r ) n

Periods 2% 4% 6% 8% 10% 12% 14% 16%

1 0.980 0.962 0.943 0.926 0.909 0.89 0.877 0.862
2 0.961 0.925 0.890 0.857 0.826 0.79 0.769 0.743
3 0.942 0.889 0.840 0.794 0.751 0.71 0.675 0.641
4 0.924 0.855 0.792 0.735 0.683 0.63 0.592 0.552
5 0.906 0.822 0.747 0.681 0.621 0.56 0.519 0.476
6 0.888 0.790 0.705 0.630 0.564 0.50 0.456 0.410
7 0.871 0.760 0.665 0.583 0.513 0.45 0.400 0.354
8 0.853 0.731 0.627 0.540 0.467 0.40 0.351 0.305
9 0.837 0.703 0.592 0.500 0.424 0.36 0.308 0.263
10 0.820 0.676 0.558 0.463 0.386 0.32 0.270 0.227
11 0.804 0.650 0.527 0.429 0.350 0.28 0.237 0.195
12 0.788 0.625 0.497 0.397 0.319 7
0.25 0.208 0.168

Present Value of Annuity $1.00 in Arrears*

1  1 
Pn = 1 − 
r  (1 + r) n 

Periods 2% 4% 6% 8% 10% 12% 14% 16%

1 0.980 0.962 0.943 0.926 0.90 0.893 0.877 0.862
2 1.942 1.886 1.833 1.783 1.73 1.690 1.647 1.605
3 2.884 2.775 2.673 2.577 2.48 2.402 2.322 2.246
4 3.808 3.630 3.465 3.312 3.17 3.037 2.914 2.798
5 4.713 4.452 4.212 3.993 3.79 3.605 3.433 3.274
6 5.601 5.242 4.917 4.623 4.35 4.111 3.889 3.685
7 6.472 6.002 5.582 5.206 4.86 4.564 4.288 4.039
8 7.325 6.733 6.210 5.747 5.33 4.968 4.639 4.344
9 8.162 7.435 6.802 6.247 5.75 5.328 4.946 4.607
10 8.983 8.111 7.360 6.710 6.14 5.650 5.216 4.833
11 9.787 8.760 7.887 7.139 6.49 5.938 5.453 5.029
12 10.575 9.385 8.384 7.536 6.81 6.194 5.660 5.197

* Payments (or receipts) at the end of each period.

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