Gleim CMA Review Updates to Part 2 15 th Edition, 1st Printing April 25, 2011

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1 Page 1 of 22 Gleim CMA Review Updates to Part 2 15 th Edition, 1st Printing April 25, 2011 NOTE: Text that should be deleted from the outline is displayed with a line through the text. New text is shown with a blue background. Introduction Preparing for and Taking the CMA Exam Page 1: This change explains that the four-part exam is no longer offered and gives some details about who should take the Transition Exam. TRANSITION TO TWO-PART EXAM The ICMA has changed the CMA program from a four-part to a two-part exam. The new two-part exam is became effective on May 1, After March 31, 2010, c Candidates will are now able to enter only into the new two-part program. Candidates for the four-part exam can transition to the new exam. If they passed old Part 2, they only have to pass new Part 2 to complete the CMA. If they passed old Part 3, they only have to pass new Part 1 to complete the CMA. If both old Parts 2 and 3 were passed, a 2-hour transition exam must be taken to complete the CMA. Old exam Parts 1, 2, 3, and 4 are no longer available to complete until December 31, Page 3: This edit reflects changes the IMA has made to their website organization. Education Requirement Candidates seeking admission to the CMA program must hold a bachelor s degree, in any area, from an accredited college or university. Degrees from foreign institutions must be evaluated by an independent agency approved by the ICMA (for a list of foreign universities that are acceptable without an evaluation, visit NOTE: Educational credentials must be submitted when applying or within 7 years of passing the examination. The educational credentials must qualify in order to be certified. Page 6: This edit reflects changes the IMA has made to their website organization. Apply for IMA membership online at Membership application forms also may be obtained by writing the Institute of Management Accountants, 10 Paragon Drive, Suite 1, Montvale, NJ , or calling (201) or (800) A sample of the two-page form appears in Appendix A on pages 540 and 541.

2 Page 2 of 22 Page 18: This new text explains the ICMA s reimplementation of the spreadsheet function in certain essay questions. Conceptual vs. Calculation Questions Some of the CMA test questions will be calculations, in contrast to conceptual questions. The ICMA has approved the use of two calculators (see below) to assist in this area. Beginning in May of 2011, certain essay questions will include a spreadsheet to assist with calculations, including net present value. Use Gleim Online to familiarize yourself with the spreadsheet function. Study Unit 1 Basic Financial Statement Analysis Page 32, Subunit 1.3, 7.: These changes update our materials to match the current Codification. 7. Comprehensive Income a. Certain income items are deliberately excluded from the calculation of net income and instead are included in comprehensive income. 1) Requiring these items to be included in net income would be misleading. They typically represent valuation adjustments, not independent economic events. b. Other comprehensive income (OCI) is the subtotal of all these items of comprehensive income that are not included in net income. 1) The three principal items of comprehensive income are typically: a) Changes in the fair values of available-for-sale securities b) Foreign currency translation adjustments c) The excess of an additional pension liability over any prior service cost prior service cost and gains and losses not recognized in pension expense c. All components of comprehensive income must be reported in a financial statement displayed with the same prominence as the other statements. 1) No specific format is specified, but reporting the components of OCI and comprehensive income below net income is encouraged. 2) EXAMPLE: Separate statement of comprehensive income Bonilla Company Statement of Comprehensive Income For Year Ended December 31, Year 1 Net income $XXX Other comprehensive income (net of tax): Foreign currency translation adjustment $XXX Minimum pension liability adjustment Prior service cost XXX Unrealized holding loss on available-for-sale securities (XXX) XXX Comprehensive income $XXX

3 8. Major FootnNote Disclosures Page 3 of 22 a. FootnNote disclosures and schedules specifically related to the income statement include the following: 1) Earnings per share 2) Depreciation schedules 3) Components of income tax expense 4) Components of pension expense Page 59 through 61, Subunit 1.7: These edits update the essay scenario to make it more relevant and correct the unofficial answer for Transactions B and E. Scenario for Essay Question 1 Merrimac Corporation began manufacturing pinball machines in the mid-fifties Year 0. By 1975 Year 25, the pinball machine market had declined significantly, and Merrimac opened a new division to develop and manufacture video games. The pinball machine division was phased out in 1980 Year 30, and since then Merrimac has concentrated exclusively on the development and manufacture of video games for both the home and commercial markets. In 1985 Year 35, Merrimac acquired a chain of video game parlors in a move to expand; this division has shown only moderate success. James Heuga has been hired as the accounting manager, and he has been assigned the task of preparing the financial statements for the fiscal year ended November 30, Year 52. Heuga is concerned about the proper financial statement presentation of several transactions that occurred during the year. Bill Werner, controller of Merrimac, has agreed to discuss these transactions with Heuga. The transactions in question include the following: A. During the year-end physical inventory, the inventory of replacement parts for a 1998 Year 48 model video game was determined to be obsolete. The inventory was written down to its salvage value and a $46,000 loss was recorded. B. At the beginning of the fiscal year, Merrimac changed the method of calculating depreciation on its building for financial reporting from the sum-of-the-years -digits method to the straight-line method. If straight-line depreciation had originally been used, the gross cumulative effect on income would be $78,000 as of the beginning of the current fiscal year. C. Three years ago, Merrimac acquired the copyright to the software for a new video game. At that time, the total useful life was estimated to be 9 years. Based on recent innovations in video software, the total useful life was changed to 6 years, effective for the current year. D. Merrimac warrants its commercial machines for 2 years subsequent to the sale. The warranty costs associated with the current year s sales are estimated to be $104,200. E. Merrimac is the plaintiff in a lawsuit that will go to trial early next year. The company s lawyers believe it probable that Merrimac will win a favorable judgment in the amount of $242,000. F. Merrimac is the defendant in a lawsuit filed by one of its customers. The company s lawyers believe it probable that Merrimac will lose and estimate the settlement to be approximately $164,000. Question 1. For each of the six transactions, explain how and why it affects Merrimac Corporation s a. Income statement, b. Statement of financial position (exclusive of net income effects), c. Cash flow statement (exclusive of net income effects), and/or d. FootnNote disclosure.

4 Essay Question 1 Unofficial Answers Page 4 of Each of the six transactions would affect Merrimac Corporation s financial statements as follows: a. Transaction A 1) The loss due to obsolescence of inventory would appear in other expenses and losses (if immaterial, in cost of goods sold) on the income statement above income before taxes. 2) The amount in ending inventory would be less. 3) The loss does not affect cash flow unless using the indirect method. 4) The write-down of obsolete inventory probably is not significant enough to be disclosed in the footnotes. If material, it must be disclosed in the footnotes. b. Transaction B 1) The cumulative effect of $78,000 for the change from sum-of-the-years -digits to straight-line depreciation represents is a change in accounting estimate inseparable from a change in accounting principle and would be reported net of tax. It is accounted for only in the period of change and any future periods affected. Thus, depreciation expense for the year of change is based on the straight-line method and the depreciable amount at the beginning of the year. 2) The opening balance in accumulated depreciation would be restated as though straight-line depreciation had been used from the beginning is not changed to reflect retrospective application of the straight-line method. Year-end accumulated depreciation equals the prechange balance at the beginning of the year plus annual straight-line depreciation. 3) The cumulative effect would appear as Straight-line depreciation for the year of change based on the depreciable amount at the beginning of the year is an adjustment in the reconciliation of net income to cash flow from operating activities. 4) The change in accounting principle must be fully described. c. Transaction C 1) The change in useful life is a change in estimate that affects present and future periods only, and the increased amortization would be reported in operating expenses causing a decline in income. The current amortization should reflect the new estimated useful life. 2) The copyright account would be decreased by the higher current period amortization. 3) The amortization of the copyright would appear as an adjustment in the reconciliation of net income to cash flow from operating activities. 4) If the change in estimate is significant, then it should be described in the footnote detailing amortization methods. Otherwise, it need not be separately disclosed. d. Transaction D 1) Warranty costs represent a contingent liability considered probable and reasonably estimated. The expense for warranty costs is included within operating expenses. 2) The estimated liability for warranty costs is generally considered a current liability. 3) The warranty expense does not directly affect cash flow; however, it would appear as an adjustment in the reconciliation of net income to cash flow from operating activities. 4) Warranty policies are described in the footnote on revenue recognition methods. If warranty expense is a departure from the amount normally incurred, then it should be described in the footnotes.

5 e. Transaction E Page 5 of 22 1) In accordance with SFAS 5, Accounting for Contingencies, Gains from contingencies that might result in gains usually are not reflected in the accounts since to do so might be to recognize revenue prior to its realization recognized until realized. Accordingly, no disclosure in the financial statements is necessary. f. Transaction F 1) This is a loss contingency that is probable and can be reasonably estimated. The loss should appear on the income statement as an Other gain or loss. 2) This event is a loss contingency that is probable and can be reasonably estimated. Therefore, the estimated liability should appear on the statement of financial position. 3) The cash flow for the contingent loss would appear as an adjustment in the reconciliation of net income to cash flow from operating activities. 4) The lawsuit should be described in the notes. Study Unit 2 Financial Performance Metrics Financial Ratios Page 65, Subunit 2.1, 1.f.: This change corrects the description of the current ratio. f. The current ratio (working capital ratio) is the most common measure of near-term solvency liquidity. 1) Current assets Current liabilities a) EXAMPLE: Current Year: $760,000 $390,000 = Prior Year: $635,000 $275,000 = b) Although working capital increased in absolute terms ($10,000), current assets now provide less proportional coverage of current liabilities than in the prior year. Page 79, Question 4: This edit corrects the answer explanation for choice (A). 4. Bond Corporation has a current ratio of 2 to 1 and a quick ratio (acid test) of 1 to 1. A transaction that would change Bond s quick ratio but not its current ratio is the A. Sale of inventory on account at cost. B. Collection of accounts receivable. C. Payment of accounts payable. D. Purchase of a patent for cash. Answer (A) is correct. (CMA, adapted) REQUIRED: The transaction that would affect the quick ratio but not the current ratio. DISCUSSION: The quick ratio is determined by dividing the sum of cash, short-term marketable securities, and accounts receivable by current liabilities. The current ratio is equal to current assets divided by current liabilities. The sale of inventory (a non not a quick current asset) on account would increases cash accounts receivable (a quick asset), thereby changing the quick ratio. The sale of inventory for cash on account, however, would be replacinges one current asset with another, and the current ratio would be is unaffected. Answer (B) is incorrect. Neither ratio would be is changed. Answer (C) is incorrect. The current, not the quick, ratio would changes. Answer (D) is incorrect. Both would decrease.

6 Page 6 of 22 Study Unit 3 Profitability Analysis and Analytical Issues Page 114, Subunit 3.1, 2.d.: This edit removes incorrect information on generated return. 2. The return generated for a corporation s owners is measured with two widely used ratios. NOTE: These examples use denominator amounts from the sample balance sheet on page 64. a. Return on assets, or ROA (also called return on total assets, or ROTA). Return on assets (ROA) = 1) EXAMPLE: Net income Average total assets Net income Average total assets = $ 42,000 ($1,800,000 + $ 1,600,000) 2 = $42,000 $ 1,700,000 = 2.47% b. Return on equity (ROE). Return on equity (ROE) = 1) EXAMPLE: Net income Average total equity Net income Average total equity = $ 42,000 ($800,000 + $ 650,000) 2 = $ 42,000 $ 725,000 = 5.79 % c. The difference in the two denominators is total liabilities. ROE will therefore always be greater than ROA. d. If the ROE percentage is higher than the ROA percentage, it is an indication that the firm is employing financial leverage effectively. In other words, if the company Is earning more on its borrowed funds than it is paying in interest, then the excess earnings accrue to the stockholders; thus, the ROE will be higher than the ROA. Page 116, Subunit 3.2, 4.: These changes clarify the meanings of measures of shareholders wealth. 4. Increasing shareholder wealth is the fundamental goal of any corporation. Two common ratios measure the degree of success of toward this goal: a. The dividend payout ratio measures what portion of accrual-basis earnings was actually paid out to common shareholders in the form of dividends. 1) Dividends to common shareholders IACS 2) Growth companies tend to have a low payout, preferring to use earnings to continue growing the firm. b. A related ratio is the dividend yield. 1) Dividend per share Market price per share c. Various investors have different desires with respect to dividend yield. Historically, many longterm investors wanted a low dividend yield because capital gains were taxed at a lower tax rate than dividends; thus, letting the earnings accumulate within the company resulted in a lower overall tax expense. However, in recent years, the tax rate of on dividends has been as low or lower than that on capital gains; thus, a high dividend yield has come into vogue. Also, investors in different circumstances have different reasons for wanting a high perspectives on dividend yield. For example, a retiree wants regular income and therefore wants to see a high dividend yield. A person who is years away from retirement would prefer a lower dividend yield with the earnings reinvested in the business.

7 Page 7 of 22 Page 118, Subunit 3.3, 1.m.: These edits improve the definition of earnings quality. m. Earnings quality is the precision of the noise term contained in earnings a measure of how useful reported earnings are as a performance indicator. It is the inverse of the variance in earnings. If earnings have a high degree of variability, many ratios will become less meaningful. 1) Consistency is an aspect of earnings is an aspect of quality. A company that has widely varying earnings levels from year to year will be said to have a low level of earnings quality because looking at a single year s earnings will not really tell you anything about the long-term aspects of the company. 2) Analysts also look at a company s accounting policies when assessing earnings quality. For example, during a period of inflation, a company using LIFO will be said to have a higher level of earnings quality than would a company with FIFO because LIFO presents more conservative numbers on both the income statement and the balance sheet. Page 125, Subunit 3.5, 11.: These edits update our materials to match the current Codification. 11. The recording types of accounting changes, such those attributable to are changes in (a) accounting principle,s and corrections of errors and (b) accounting estimates, and (c) the reporting entity can impact the calculation of financial ratios. Accounting changes are defined as changes in the application or implementation of accounting principles, such as switching from the LIFO to the FIFO method of inventory valuation and error corrections affect financial ratios. a. If A change in accounting principle or the reporting entity is retrospectively applied to financial statements of prior periods presented comparatively have been restated, they will be consistent with those of the current period and ratio analysis will not be unduly impacted Error corrections related to prior periods result in restatement. After retrospective application or restatement, the comparative financial statements and ratios should be comparable and consistent. b. Reinstatement, hhowever, involves changing prior years net income and related EPS figures, which may undermine stockshareholders confidence in the accounting methodologys. c. Accounting changes are accounted for by retroactive restatement only in special cases. The following changes in principle require a retroactive restatement of financial statements with full footnote disclosure in the year of the change: A change in accounting principle occurs when an entity (1) adopts a generally accepted principle different from the one previously used, (2) changes the method of applying a generally accepted principle, or (3) changes to a generally accepted principle when the principle previously used is no longer generally accepted. 1) Change from LIFO to another inventory pricing method. Retrospective application, if practicable, is required for all direct effects and the related income tax effects of a change in principle. a) An example of a direct effect is an adjustment of an inventory balance to implement a change in the method of measurement. b) Retrospective application requires that carrying amounts of (1) assets, (2) liabilities, and (3) retained earnings at the beginning of the first period reported be adjusted for the cumulative effect of the new principle on all periods not reported. i) All periods reported must be individually adjusted for the period specific effects of applying the new principle.

8 2) Change from the completed-contract to the percentage-of-completion method (or vice versa). 3) Change to or from the full-cost method used in the extractive industries. 4) Change in the reporting entity resulting from a business combination or a spin-off. Page 8 of 22 5) Change from the retirement-replacement-betterment accounting to depreciation accounting for railroad track structures. 6) Change to the method of accounting required by a new pronouncement. d. For all other changes in accounting principles, the cumulative effect of the change is included in the income statement in the year of change (minus related tax effects). This cumulative effect is to be shown in a separate section of the income statement after extraordinary items. A change in accounting estimate results from new information and a reassessment of the future benefits and obligations represented by assets and liabilities. Its effects should be accounted for only in the period of change and any future periods affected, i.e., prospectively. 1) The new accounting method is used in the year of change. A change in estimate inseparable from (effected by) a change in principle is accounted for as a change in estimate. An example is a change in a method of depreciation, amortization, or depletion of long-lived, nonfinancial assets. 2) Such changes present problems for those attempting to calculate financial ratios because there is a question as to whether the effect of the change should be included in the ratio. 3) Changes in accounting estimates, such as the length of the useful life or salvage value of fixed assets, are accounted for prospectively (in the current and future years). Prior years financial statements are not restated. Only the current and future years are affected. Again, this may cause a blip in the interpretation of ratios. e. Retroactive restatement is also required for error corrections. The effects of errors on periods prior to the statements is reported as an adjustment to beginning retained earnings in the retained earnings statement. In other words, errors are treated as prior period adjustments and have no impact on the income statement for the current period. Analysts should be alert to notice any prior period adjustments that might have an impact on the calculation of ratios. A change in reporting entity is retrospectively applied to interim and annual statements. 1) A change in reporting entity does not result from a business combination or consolidation of a variable interest entity. f. An accounting error results from (1) a mathematical mistake, (2) a mistake in the application of GAAP, or (3) an oversight or misuse of facts existing when the statements were prepared. A change to a generally accepted accounting principle from one that is not is an error correction, not an accounting change. 1) An accounting error related to a prior period is reported as a prior-period adjustment by restating the prior-period statements. Restatement requires the same adjustments as retrospective application of a new principle.

9 Page 129, Subunit 3.7, 2.b.3) and 2.d.: These changes update our materials to match the current Codification. b. Special purpose entities (SPEs). Page 9 of 22 1) A firm may create another firm for the sole purpose of keeping the liabilities associated with a specific project off the parent firm s books. 2) For example, when a company wishes to construct a factory, large amounts of new debt must be taken on. A special purpose entity can be established solely to build and operate the new plant while absorbing the debt incurred during construction. a) Once the plant is complete, the parent firm will often establish a take-or pay contract with the SPE. Under a take-or-pay arrangement, the company agrees to either buy all the output of the factory or to make guaranteed payments. b) This way, the financial solvency of the SPE is ensured and the company has acquired a steady source of supply without taking on a large debt burden. 3) In late 2001, the national media revealed that Enron Corporation had hidden a huge amount of debt for which it was responsible by off-loading it onto the balance sheets of SPEs. These SPEs had been deliberately structured so that Enron would not have to consolidate them. a) In 2003, the FASB responded to these abuses by issuing pronouncements on variable interest entities (VIEs). Any arrangement that meets the criteria of a VIE must be reported on a consolidated basis with another entity. c. Operating leases. 1) A long-term contract to acquire property or equipment may be structured in such a way that the full amount of the debt does not appear on the firm s balance sheet. d. Sale of receivables Factoring receivables with recourse. 1) Historically, a sale of receivables, sometimes called a factoring transaction, has been a means of off-balance-sheet financing. The company transfers all rights to receivables to a financial institution, who will service (collect) the receivables. Thus, the company receives its money from the financial institution and removes the receviables from the balance sheet. However, in some cases, the transferor still has some liability with respect to those receivables. That liability, possibly contingent, does not appear on the balance sheet Factoring (selling) accounts receivable to a finance company is a strategy used by firms who need to accelerate their cash flows or who simply do not wish to maintain a collection operation. a) If the factoring transaction is with recourse, the firm remains contingently liable to the finance company in the case of debtor default. This contingent liability does not have to be reported on the company s balance sheet.

10 Page 139, Core Concepts: These edits align the Core Concepts with the changes in Subunit 3.7. Effects of Off-Balance-Sheet Financing Page 10 of 22 Reducing a company s debt load improves its ratios, making its securities more attractive investments. Also, many loan covenants contain restrictions on the total debt load that a company is permitted to carry. However, reducing debt and hiding it are two very different things. Firms that carry extensive debt financing but attempt to disguise the fact are engaging in off-balance-sheet financing. Off-balance-sheet financing takes three four principal forms: investments in unconsolidated subsidiaries, special purpose entities (SPEs)/variable interest entities (VIEs), and operating leases, and factoring receivables with recourse. Pages 140 through 160 improve upon the update to Study Unit 3 questions that was released in the Update pdf of December, These pages reflect the in-book questions that should be studied for Subunit 3.1 through Subunit 3.4. Click on the following link to view these pages:

11 Page 11 of 22 Page 166, Question 63: This change updates this question to match the current Codification. 77. Careful reading of an annual report will reveal that offbalance-sheet debt includes A. Amounts due in future years under operating leases. B. Transfers of accounts receivable without recourse. C. Current portion of long-term debt. D. Amounts due in future years under capital leases. Answer (A) is correct. (CMA, adapted) REQUIRED: The off-balance-sheet debt. DISCUSSION: Off-balance-sheet debt includes any type of liability that for which the company is responsible for but that does not appear on the balance sheet. The most common example is the amount due in future years on operating leases. Under SFAS 13, operating leases are not capitalized; instead, only the periodic payments of rent are reported when actually paid. Capital leases (those similar to a purchase) must be capitalized and reported as liabilities. Answer (B) is incorrect. Transfers of accounts receivable without recourse do not create a liability for the company. This transaction is simply a transfer of receivables for cash. Answer (C) is incorrect. The current portion of long-term debt is shown on the balance sheet as a current liability. Answer (D) is incorrect. Amounts due in future years under capital leases are required to be recognized under SFAS 13 GAAP. Study Unit 6 Managing Current Assets Page 267, Subunit 6.6, 8.c.: This change corrects the effective rate calculation. c. Once again, the dollar amounts involved are not needed to determine the effective rate. Stated rate Effective rate with comp. balance = (1.0 Compensating balance %) Effective rate = Standard Stated rate (1.0 Compensating balance %) = 6% (100% 10%) = 6% 90% = 6.67% Page 271, Core Concepts, Short-Term Financing: This change corrects the effective rate calculation. The effective rate on any financing arrangement is the ratio of the amount the firm must pay to the amount the firm gets use of. The most basic statement of this ratio is: Effective interest rate + = Net interest expense Usable Funds

12 Study Unit 8 Decision Analysis and Risk Management Page 12 of 22 Page 391, Subunit 8.4, 2.a.3): The changes correct the marginal costs and profits in the table. 3) The monopolist has the power to set output at the level where profits are maximized, that is, where MR = MC. This is called price searching. Price Searching for a Monopolist Units of Revenue Cost Profit Output Total Marginal Total Marginal Total Marginal 1 $ 960 $960 $ 800 $800 $ 160 $ , , , , , , , , , , , (120) (220) 7 4, , ,140 0 (300) (780) 8 4, , ,300 (1,040) (480) (1,040) Page 426, Question 29: This edit corrects and improves the answer explanation for choice (B). 29. The total number of units needed to break even if the budgeted direct labor costs were $2 for plastic frames instead of $3 is A. 154,028 units. B. 144,444 units. C. 156,000 units. D. 146,177 units. Answer (B) is correct. (CMA, adapted) REQUIRED: The breakeven point in units if labor costs for the plastic frames are reduced. DISCUSSION: If the labor costs for the plastic frames are reduced by $1, the composite unit contribution margin will be $27 {[($10 $2 $3 2) + (3) [($15 $3 $5) 3]}. Hence, the new breakeven point is 144,444 units [4 units ($975,000 FC $27)]. Study Unit 9 Investment Decisions I Pages 455 through 459, Subunit 9.1, 6. through Subunit 9.2, 3.b.3): These edits improve upon an earlier update to further clarify the nontaxability of the recovery of salvage value. 6. Relevant cash flows are a much more reliable guide when judging capital projects, since only they provide a true measure of a project s potential to affect shareholder value. a. The relevant cash flows can be divided into three categories: 1) Net initial investment a) Purchase of new equipment b) Initial working capital requirements c) After-tax proceeds from disposal of old equipment 2) Annual net cash flows a) After-tax cash collections from operations (excluding depreciation effect) b) Tax savings from depreciation deductions (depreciation tax shield) 3) Project termination cash flows a) After-tax Cash proceeds from disposal of new equipment (untaxed) b) After-tax Recovery proceeds from recovery of working capital (untaxed)

13 Page 13 of 22 b. EXAMPLE: A company is determining the relevant cash flows for a potential capital project. The company has a 40% tax rate. 1) Net initial investment: a) The project will require an initial outlay of $500,000 for new equipment. b) The company expects to commit $12,000 of working capital for the duration of the project in the form of increased accounts receivable and inventories. c) Calculating the after-tax proceeds from disposal of the existing equipment is a two-step process. i) First, the book gain or loss is determined. Disposal value $ 5,000 Less: book value (20,000) Accrual-basis loss on disposal $(15,000) ii) The after-tax effect on cash can then be calculated. Disposal value $ 5,000 Add: tax savings on loss ($15,000.40) 6,000 After-tax cash inflow from disposal $11,000 d) The cash outflow required for this project s net initial investment is therefore $(501,000) [$(500,000) + $(12,000) + $11,000]. 2) Annual net cash flows: a) The project is expected to generate $100,000 annually from ongoing operations. i) However, 40% of this will have to be paid out in the form of income taxes. Annual cash collections $100,000 Less: income tax expense ($100,000.40) (40,000) After-tax cash inflow from operations $ 60,000 b) The project is slated to last 8 years. i) The new equipment is projected to have no a $25,000 salvage value and will to generate $62,500 per year in depreciation charges ($500,000 8). NOTE: On the CMA exam, salvage value is never subtracted when calculating the depreciable base for tax purposes. ii) The old equipment has 4 years of service life remaining ($20,000 4 years = $5,000 annual depreciation). iii) Unlike the income from operations, the higher depreciation charges will generate a tax savings. This is referred to as the depreciation tax shield. iv) The tax savings generated by the higher depreciation for the first 4 years is $23,000 [($62,500 $5,000).40] and for the last 4 years is $25,000 [($62,500 $0).40]. c) The annual net cash inflow from the project is thus $83,000 ($60,000 + $23,000) for the first 4 years and $85,000 ($60,000 + $25,000) for the last 4 years. 3) Project termination cash flows: a) No proceeds are expected from disposal of the new equipment at the end of the project Only annual-basis revenues and expenses are taxable. Thus, the two cash flows received upon project termination (the proceeds from disposal of the new equipment and the recovery of working capital) have no tax consequences.

14 i) First, the book gain or loss is determined. Disposal value $0 Less: book value 0 Accrual-basis gain on disposal $0 If depreciation is properly applied, the book value of the new equipment on the disposal date will equal its salvage value. Thus, the disposal transaction will generate no accural-basis gain. ii) The after-tax effect on cash can then be calculated. Accrual-basis gain on disposal $0 Less: tax liability on gain ($0.40) 0 After-tax cash inflow from disposal $0 The recovery of working capital is also a pure-cash transaction. It does not represent revenue. b) Once the project is over, the company will recover the $12,000 of working capital it committed to the project. c) The net cash inflow upon project termination is therefore $12 37,000 ($25,000 + $12,000). Page 14 of 22 c. As the preceding example indicates, tax considerations are essential when considering capital projects. 7. Other important concepts include the following: a. Three crucial terms. 1) An incremental cash flow is the difference in cash received or disbursed resulting from selecting one option instead of another. 2) A sunk cost is one that is either already paid or irrevocably committed to incur. Because it is unavoidable and will therefore not vary with the option chosen, it is not relevant to future decisions. a) An example is the amount already spent on manufacturing equipment. 3) An opportunity cost is the maximum benefit forgone by using a scarce resource for a given purpose and not for the next-best alternative. a) In capital budgeting, the most basic application of this concept is the desire to place the company s limited funds in the most promising capital project(s). b) An even more important application is the shareholders opportunity cost of capital. This is the rate of return the company s shareholders could earn by taking their funds and investing them elsewhere at a similar level of risk. i) Shareholders opportunity cost of capital is one choice for a firm s hurdle rate. b. Effects of inflation on capital budgeting. 1) Inflation raises the hurdle rate. In an inflationary environment, future dollars are worth less than today s dollars. Thus, the firm will require a higher rate of return to compensate. c. Post-investment audits should be conducted to serve as a control mechanism and to deter managers from proposing unprofitable investments. 1) Actual-to-expected cash flow comparisons should be made, and unfavorable variances should be explained. The reason may be an inaccurate forecast or implementation problems.

15 Page 15 of 22 2) Individuals who supplied unrealistic estimates should have to explain differences. Knowing that a post-investment audit will be conducted may cause managers to provide more realistic forecasts in the future. 3) The temptation to evaluate the outcome of a project too early must be overcome. Until all cash flows are known, the results can be misleading. 4) Assessing the receipt of expected nonquantitative benefits is inherently difficult. Stop and review! You have completed the outline for this subunit. Study multiple-choice questions 1 through 27 beginning on page DISCOUNTED CASH FLOW ANALYSIS 1. A dollar received in the future is worth less than a dollar received today. Thus, when analyzing capital projects, the management accountant must discount the relevant cash flows using the time value of money. a. A firm s goal is for its discount rate to be as low as possible. 1) The lower the firm s discount rate, the lower the hurdle the company must clear to achieve profitability. For this reason, the rate is sometimes called the hurdle rate. b. The two most widely used rates in capital budgeting are 1) The firm s weighted-average cost of capital and 2) The shareholders opportunity cost of capital. c. A common pitfall in capital budgeting is the tendency to use the company s current rate of return as the benchmark. This can lead to rejecting projects that should be accepted. 1) EXAMPLE: A firm s current rate of return on all projects is 12%. Its shareholders opportunity cost of capital is 10%. The company incorrectly rejects a project earning 11%. d. The two principal methods for projecting the profitability of an investment are net present value and internal rate of return. 2. The net present value (NPV) method expresses a project s return in dollar terms. a. NPV nets the expected cash streams related to a project (inflows and outflows), then discounts them at the hurdle rate, also called the desired rate of return. 1) If the NPV of a project is positive, the project is desirable because it has a higher rate of return than the company s desired rate. b. EXAMPLE: 1) The company discounts the relevant net cash flows using a hurdle rate of 6% (its desired rate of return). Net Cash 6% PV Discounted Period Flow Factor Cash Flows Initial Investment $(501,000) $(501,000) Year , ,642 78,302 Year , ,530 73,870 Year , ,651 69,688 Year , ,991 65,743 Year 5 85, ,517 Year 6 85, ,922 Year 7 85, ,530 Year 8 101,8 85, ,870 53,330 Termination 37, ,214 Net Present Value $ 9,653 43,117

16 Page 16 of 22 2) Because the project has net present value > $0, it is profitable given the company s hurdle rate. 3. The internal rate of return (IRR) expresses a project s return in percentage terms. a. The IRR of an investment is the discount rate at which the investment s NPV equals zero. In other words, it is the rate that makes the present value of the expected cash inflows equal the present value of the expected cash outflows. 1) If the IRR is higher than the company s desired rate of return, the investment is desirable. b. EXAMPLE: 1) The discounted cash flows used in the NPV exercise on the previous page can be recalculated using a higher discount rate (a higher rate will drive down the present value) in an attempt to get the solution closer to $0. Net Cash 7% PV Discounted Period Flow Factor Cash Flows Initial Investment $(501,000) ($501,000) Year , ,963 76,852 Year , ,255 71,159 Year , ,855 65,888 Year , ,743 61,007 Year 5 85, ,604 57,849 Year 6 85, ,639 53,564 Year 7 85, ,934 49,597 Year , ,249 45,923 Termination 37, ,900 Net Present Value $(10,759) 830 2) The higher hurdle rate causes the NPV to be negative A slightly higher discount rate will produce an NPV of $0. Thus, the IRR of this project is somewhere around 6.5% just over 8%. 3) Because the company s desired rate of return is 6%, the project should be accepted, the same decision that was arrived at using the net present value method. Page 466, Subunit 9.4, 2.a.: The changes correct the amounts for this example. a. EXAMPLE: A company has $200,000 to invest. It can therefore either invest in Project F below or in Projects G and H. Initial Year 1 Year 2 Year 3 Year 4 Project F $(200,000) $140,000 $100, Project G (88,950) 30,000 30,000 $30,000 $30,000 Project H (88,440) 30,000 28,000 28,000 34,000 1) Discounting each project at 6% results in the following: Divided by: Equals: NPV Initial Investment Profitability Index Project F $21, $200, Project G 15, , Project H 15, , ) In an environment of capital rationing, the company can see that it should invest first in Project H, then in Project G, and, if new funding is found, last in Project F.

17 Page 467, Core Concepts for Subunit 9.5: This edit aligns the Core Concepts with the Subunit 9.1 outline. Project termination cash flows After-tax Cash proceeds from disposal of new equipment (untaxed) After-tax proceeds from r Recovery of working capital (untaxed) Page 17 of 22 Page 499, Subunit 9.6, Essay Questions: 9.6 ESSAY QUESTIONS Scenario for Essay Questions 1, 2 Kravel Corporation is a diversified company with several manufacturing plants. Kravel s Dayton Plant has been supplying parts to truck manufacturers for over 30 years. The last shipment of truck parts from the Dayton Plant will be made December 31, 2006 Year 6. Kravel s management is currently studying three alternatives relating to its soon-to-be-idle plant and equipment in Dayton. 1. Wasson Industries has offered to buy the Dayton Plant for $3,000,000 cash on January 1, 2007 Year Harr Enterprises has offered to lease the Dayton facilities for 4 years beginning on January 1, 2007 Year 7. Harr s annual lease payments would be $500,000 plus 10% of the gross dollar sales of all items produced in the Dayton Plant. Probabilities of Harr s annual gross dollar sales from the Dayton Plant are estimated as follows: Annual Gross Dollar Sales Estimated Probability $2,000, ,000, ,000, ,000, Kravel is considering the production of souvenir items to be sold in connection with upcoming sporting events. The Dayton Plant would be used to produce 70,000 items per month at an annual cash outlay of $2,250,000 during 2007 Year 7, 2008 Year 8, and 2009 Year 9. Linda Yetter, Vice President of Marketing, has recommended a selling price of $5 per item and believes the items will sell uniformly throughout 2008 Year 8, 2009 Year 9, and 2010 Year 10. The adjusted basis of the Dayton Plant as of the close of business on December 31, 2006 Year 6, will be $4,200,000. Kravel has used straight-line depreciation for all capital assets at the Dayton Plant. If the Dayton Plant is not sold, the annual straight-line depreciation charge for the plant and equipment will be $900,000 each year for the next 4 years. The market value of the plant and equipment on December 31, 2010 Year 10, is estimated to be $600,000. Kravel requires an after-tax rate of return of 16% for capital investment decisions and is subject to corporate income tax rates of 40% on operating income and 20% on capital gains. Questions 1. Calculate the present value (at December 31, 2006 Year 6) of the expected after-tax cash flows for each of the three alternatives available to Kravel Corporation regarding the Dayton Plant. Assume all recurring cash flows take place at the end of the year. 2. Discuss the additional factors, both quantitative and qualitative, Kravel Corporation should consider before a decision is made regarding the disposition or use of the idle plant and equipment at the Dayton Plant.

18 Page 18 of 22 Page 501, Essay Questions 1, 2 Unofficial Answers, 1: These changes correct the Unofficial Answer for the Essay question. Alternative 3 Keep plant and produce souvenir items: Income taxes should be recognized in the years in which the revenues are earned. Tax expense for Years 8, and 9, and 10 is therefore $780,000 [($4,200,000 $2,250,000).40]. Year 10 taxes are $1,680,000 ($4,200,000.40). Since depreciation expense is included in cost of goods sold, the depreciation tax shield only arises in years when product is sold. The shield for Years 8 and 9 is $360,000 ($900,000.40). The shield for Year 10 is $720,000, consisting of the $360,000 arising from cost of goods sold plus $360,000 for the current year when the building is not being used for production. Since the book value of the plant is expected to equal its salvage value at the end of Year 10, there will be no tax effect from an accrual-basis gain or loss, and thus the relevant cash flow is the entire proceeds. Year 7 Year 8 Year 9 Year 10 Sales revenue (70,000 $5 12 months) $ 0 $ 4,200,000 $ 4,200,000 $ 4,200,000 Less: annual cash outlays (2,250,000) (2,250,000) (2,250,000) 0 Expected annual cash flows $(2,250,000) $ 1,950,000 $ 1,950,000 $ 4,200,000 Less: income taxes 0 (780,000) (780,000) (780,000) (1,680,000) After-tax cash flows $(2,250,000) $ 1,170,000 $ 1,170,000 3,420,000 $ 2,520,000 Add: depreciation tax shield 0 360, , ,000 Add: termination salvage value ,000 Net after-tax cash flows $(2,250,000) $ 1,530,000 $ 1,530,000 4,740,000 $ 3,840,000 Times: PV factor Present value of after-tax cash flows $(1,939,500) $ 1,136,790 $ 980,730 2,616,480 $ 2,119,680 Net present value of after-tax cash flows 2,794,500 $ 2,297,700 Page 501, Subunit 9.6, Essay Questions 1, 2, Unofficial Answers, 2: 2. While considering its decision regarding the Dayton Plant, Kravel must consider That all of Alternative 1 s cash flows take place immediately, making it the least risky of the three. The adequacy of the cash flows estimates and the appropriateness of the hurdle rate used. The timing of cash flows of each of the alternatives in light of the firm s overall cash budget. The possibility that the manufacture of truck parts will once again be a profitable use of the plant. Alternative 1 precludes this option permanently and, under Alternative 2, it will not be available until 2011 Year 11.

19 Page 19 of 22 Study Unit 10 Investment Decisions II and Ethical Considerations for the Organization Pages 519 and 520, Questions 1 through 4: These changes are the result of the ICMA s clarification of the nontaxability of the recovery of salvage value. QUESTIONS 10.1 Comprehensive Examples of Investment Decisions Questions 1 and 2 are based on the following information. McLean, Inc. is considering the purchase of a new machine that will cost $160,000. The machine has an estimated useful life of 3 years. Assume that 30% of the depreciable base will be depreciated in the first year, 40% in the second year, and 30% in the third year. The new machine will have a $10,000 resale value at the end of its estimated useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a 40% estimated income tax rate and a 16% hurdle rate to evaluate capital projects. Discount rates for a 16% rate are as follows: Present Value of an Present Value of $1 Ordinary Annuity of $1 Year Year Year What is the net present value of this project? A. $3,278 30,910 B. $5,842 8,834 C. $(568) 6,270 D. $30,910 2,424 Answer (B) is correct. (CMA, adapted) REQUIRED: The NPV of the new machine. DISCUSSION: The NPV is the excess of the present values of the estimated net cash inflows over the net cost of the investment ($160,000). The future cash inflows consist of $85,000 per year savings minus income taxes. Given salvage value of $10,000, the depreciable base is $150,000 ($160,000 cost $10,000). The first and third years depreciation deduction is $45,000 ($150,000 30%), leaving $40,000 ($85,000 $45,000) of taxable income. Thus, first- and thirdyear tax expense is $16,000 ($40,000 40%). Accordingly, the net cash inflow in both the first and third years is $69,000 ($85,000 $16,000). The $60,000 ($150,000 40%) depreciation deduction in the second year results in $25,000 ($85,000 $60,000) of taxable income. Second-year tax expense is therefore $10,000 ($25,000 40%), and the second-year net cash inflow is $75,000 ($85,000 $10,000). The net cash inflow from sale of the machine is $10,000. No tax is paid on this amount because the remaining book value is also $10,000. The present value of these net cash inflows is determined using the appropriate PV of $1 factors for a hurdle rate of 16%. Hence, the net present value is $5,842 ($165,842 PV $160,000 cost). $69, = $ 59,478 $75, = 55,725 $69, = 44,229 $10, = 6,410 PV of net cash inflows $165,842 The NPV method discounts the expected cash flows from a project using the required rate of return. A project is acceptable if its NPV is positive. The future cash inflows consist of $85,000 of saved expenses per year minus income taxes after deducting depreciation. In the first year, the after-tax cash inflow is $85,000 minus taxes of $14,800 {[$85,000 ($160,000 30%) depreciation] 40%}, or $70,200. In the second year, the after-tax cash inflow is $85,000 minus taxes of $8,400 {[$85,000 ($160,000 40%) depreciation] 40%}, or $76,600. In the third year, the after-tax cash inflow

20 Page 20 of The payback period for this investment would be A years. B years. C years. D years. (excluding salvage value) is again $70,200. Also in the third year, the untaxed cash inflow from the salvage value is $10,000. Accordingly, the total for the third year is $80,200 ($70,200 + $10,000). The sum of these cash flows discounted using the factors for the present value of $1 at a rate of 16% is calculated as follows: $70, = $ 60,512 $76, = 56,914 $80, = 51,408 Discounted cash inflows $166,270 Thus, the NPV is $8,834 ($168,834 $160,000 initial outflow). Answer (A) is incorrect. The amount of $3,278 assumes that taxes must be paid on the salvage value The amount of $30,910 equals the present value of a 3-year annuity of $85,000 discounted at 16%, minus $160,000. Answer (C) is incorrect. The amount of $(568) omits salvage value from the calculation Improperly subjecting the cash proceeds received from salvage value to income taxation results in an NPV of $6,270. Answer (D) is incorrect. The amount of $30,910 equals the present value of a 3-year annuity of $85,000 discounted at 16%, minus $160,000 Failing to include the cash proceeds from salvage value results in an NPV of $2,424. Answer (C) is correct. (CMA, adapted) REQUIRED: The payback period for an investment. DISCUSSION: The payback period is the number of years required for the cumulative undiscounted net cash inflows to equal the original investment. The future net cash inflows consist of $69,000 70,200 in Year 1 and 3, $75,000 76,600 in Year 2, and $10,000 upon resale. After 2 years, the cumulative undiscounted net cash inflow equals $144, ,800. Thus, $16,000 13,200 ($160,000 $144, ,800) is to be recovered in the Year 3, and payback should be complete in approximately years [2 years + ($16,000 13,200 $69,000 80,200 net cash inflow in third year)]. Answer (A) is incorrect. This number of years assumes an $85,000 annual net cash inflow Improperly subjecting the cash proceeds received from salvage value to income taxation results in a payback period of Answer (B) is incorrect. This number of years is the estimated useful life of the machine. Answer (D) is incorrect. This number of years results from adding income tax expense to the cost savings each year failing to account for the cash proceeds from salvage value.