CMA2_P2_Practice_Answers

HOCK international ♦ www.hockinternational.com ♦ 1-866-807-4625 ♦ 1-281-652-5768 The Institute of Certified Management Accountants (ICMA) published a set of practice questions and answers in 2008 to help candidates prepare for essay exam questions. These are actual “retired” questions from the computer-based CMA exam, and are used here with permission from the ICMA. This document contains the answers from the ICMA. These practice questions will help you test your understanding of the concepts, theories and formulas that you have studied in Part 2 by requiring you to apply what you have learned to unique and varying situations. You will encounter different scenarios and applications on your actual exam than presented here, so it is essential that you understand the underlying con- cepts. In general, it will not be helpful to memorize questions and answers. In order to simulate the actual Prometric testing environment, we have formatted the Practice Questions so that they can be viewed on one-half of the computer screen. Size the Adobe Reader window so that it is as long as your monitor and fills the left half of your screen. Then, open Notepad or any similar basic text editor (not a full word processor like Microsoft Word) and position the Notepad window beside the window containing the questions. Size the Note- pad window so that it is as long as your monitor and fills the right half of your screen. With the Adobe Reader question window on the left and the Notepad answer window on the right, compose your answers to the questions directly into the Notepad window as you read the questions in Adobe Reader. We are not able to calculate a score for your answer. However, by comparing your answer with the suggested answer, you should be able to get a good idea of whether you know enough about the topic. The real value in this exercise is in learning what kind of questions you might face and becoming comfortable with reading a long question on the screen and composing your answer directly on the computer. The ICMA has provided one sample question with a grading guide, which you can also down- load from My Studies. This should help you get a feel for how the written answers are graded. We encourage you to use these problems as prescribed in the CMA Part 2 Study Plan, which you can download from the HOCK international web site. If you have any questions while studying for the CMA Part 2 Exam, please contact us and we will guide you. Revised July 2010 2010 CMA Part 2 Practice Answer #1 Financial Statement Analysis A. Liquidity is the ability of an asset to be converted into cash without significant price concessions. Liquidity is important to Sentech because current obligations will continue if there is a strike. Understanding the company’s ability to meet its obligations even if nor- mal cash receipts are not forthcoming would give management an indication of whether or not – and for how long – it could weather a strike. Lack of liquidity can limit a company’s financial flexibility, making it unable to take advantage of discounts and other profitable opportunities. Liquidity problems can also lead to financial distress or bankruptcy. B. Measures of liquidity include the following. • Current ratio: current assets/current liabilities • Quick ratio (or acid-test ratio): (cash + marketable securities + accounts receiva- ble)/current liabilities. The quick ratio excludes inventory and prepaid expenses from cash resources. • Cash ratio: (cash + marketable securities)/current liabilities • Only cash and securities that are easily convertible into cash are used. • Net working capital: current asset – current liabilities • Net working capital ratio: net working capital/total assets • Sales to working capital: sales/average net working capital • Accounts receivable turnover: net sales/average gross receivables • This ratio can also be calculated in days. • Inventory turnover: cost of goods sold/average inventory • This ratio can also be calculated in days. C. Based on the parameters set down by the controller, either the quick ratio or the cash ratio would be best. The reason that these ratios are best is because they focus on the most liquid assets, excluding prepaid expenses and inventories. During a strike inventories would not be a source of cash. The cash ratio excludes receivables as well, and would be the most conservative measure. The cash ratio would reflect the fact that the collection of receivables would be slowed during a strike. D. Types of short-term credit include: • Short-term loans – borrowing from banks for 1 year or less • Trade credit - borrowing from suppliers by delaying payment • Commercial paper – only available to large credit-worthy businesses • Promissory notes – IOU’s at interest rate and term • Line of credit – can borrow up to a certain limit from bank without asking 2010 CMA Part 2 Practice Answer #2 Financial Instruments and Cost of Capital A. Financing plan (dollars in millions): Current structure Percent of total Funds Needed Retained earnings External sources Debt $175 35% $28 $28 Preferred $ 50 10% $ 8 $ 8 Common $275 55% $44 $15 $29 Totals $500 100% $80 $15 $65 Financing sources will be as follows: New Debt $28 million New Preferred stock 8 million Retained earnings 15 million New Common stock1 29 million Total $80 million 1 $29 million ÷ $58 per share = 500,000 new common shares B. Weighted incremental cost of capital % of Capital Structure Cost Weighted Cost Debt 35% 6%1 2.10% Preferred 10% 12% 1.20% Common 55% 16% 8.80% Cost of Capital 12.10% 1 Pre-tax 10% x (1- tax rate) = 6.00% C1. If the corporate tax rate was increased, the after-tax cost of debt would be reduced, thereby reducing the cost of capital. In other words, the tax shield of debt becomes more valuable to the firm. C2. When the banks indicate they are raising rates, the rest of the debt market generally raises rates. The higher cost of debt will increase the overall cost of capital. C3. Beta is a measure of risk. According to the Capital Asset Pricing Model, the cost of equity is directly related to risk. As risk is reduced the cost of equity is reduced and correspon- dingly the overall cost of capital is reduced. C4. In general, a significant increase in the percent of debt in the capital structure (especially in this case where the current structure is deemed optimal), results in more risk for the firm. This increases its cost of debt and its cost of equity. The increase in the cost of equi- ty will most likely offset the fact that debt has a lower relative. The result here is that the cost of capital should increase. 2010 CMA Part 2 Practice Answer #3 Pricing A. The main difference between the two methods of pricing is a different starting point for determining product price. Mark-up pricing is based on existing costs and a desired return. The price is then determined by adding the product cost and the desired mark-up. This method provides little incentive to reduce costs as long as sales are profitable. Using target costing, product prices are determined by reviewing competitive pricing and setting prices according to market strategies and positioning. Target costing moves from the existing market prices to the process of managing the product costs in order to earn a desired return. Target costing motivates process improvements. The process is intended to increase or maintain sales while increasing product profitability by reducing product costs through the elimination of non-value added activities. B. Calculate earnings before taxes: Sales* $2,528,100 Less material & labor 1,223,400 (1,348,400 – 125,000) Less overhead 375,000 (500,000 x .75) Contribution 929,700 Selling expense 250,000 Admin expense 180,000 Interest expense 30,000 Earnings before taxes $ 469,700 * Vanilla $53 x 10,200 540,600 Chocolate $53 x 12,500 662,500 Caramel $50 x 12,900 645,000 Raspberry $50 x 13,600 680,000 C. The preferable pricing method for Kolobok is target costing as it is projected to significant- ly increase the return on sales from 7% to 18.5% ($469,700 ÷ $2,528,100) while main- taining the existing sales level. Target costing will also motivate management to improve internal processes to reduce costs to further improve profitability, particularly for any product where the proposed target price is lower than the previous price. This method will also force Kolobok to be continually aware of the actions of its competitors and trends in the marketplace in order to make adjustments when needed. 2010 CMA Part 2 Practice Answer #4 Future Value and Risk Management A. The required cost per ton can be calculated as follows: Required fund at the end of year 15 Amount in today's dollars $14,000,000 Future value factor (15 years, 4%) 1.801 Required fund $25,214,000 Value of current fund at the end of year 15 Current fund value $3,000,000 Future value factor (15 years, 7%) 2.759 Value in 15 years $8,277,000 Estimated additional amount needed in year 15 Required fund $25,214,000 Value of current fund in 15 years 8,277,000 Additional amount needed $16,937,000 Annual funding required Additional amount needed $16,937,000 FV of Annuity factor (15 years, 7%) ÷ 25.129 Annual funding required $ 674,002 Cost per ton Annual funding required $ 674,002 Annual output (Tons) ÷ 1,350,000 Cost per ton $ 0.50 B. Major uncertainties and their effect on the charge per ton could include the following. • Estimate of the cost in today's dollars for the reclamation. Since the reclamation will not be done for 15 years, there is considerable uncertainty. The technology could change, resulting in higher or lower cost. The law or associated regulations could also change. • Rate of escalation of the reclamation cost. Future cost increase levels are difficult to project. • Estimated earnings level of the fund. The 15-year horizon is a long period of time. In- vestment returns from the equities and fixed income markets can fluctuate significantly from year to year. • Tax regulations can change. This would affect the annual amount deposited to the fund because earnings could become taxable. • The mine output could change. Total output could be different and/or the yearly amounts may not be uniform as projected. 2010 CMA Part 2 Practice Answer #4 Future Value and Risk Management C. Changes in tax regulations could affect the analysis in the following ways. 1) If amounts collected for reclamation and deposited in external funds were taxable, • GML would have to charge its customers more each year. • The charge per ton would initially be adjusted by dividing the amount by (1-tax rate) and offsetting that by an amount equal to the present value of the tax ben- efit in 15 years when reclamation occurs and a tax benefit is received. 2) If the earnings on the fund were taxable, • The charge per ton would have to increase to offset the tax payments. • GML may want to communicate to the trustee that it should be more aggressive (i.e., take more risk) so it earns higher pre-tax returns. • GML may want the trustee to invest in tax-exempt instruments. This decision should take into account the yields of tax exempt vs. taxable instruments. 2010 CMA Part 2 Practice Answer #5 Cost-Volume-Profit Analysis A. The contribution margin is 75%1 or $3.75 per adult admission, and $1.875 per student admission. The mix is 20% adult (30 ÷ 150) and 80% student (120 ÷ 150). The weighted average contribution margin is: WACM = .20($3.75) + .80 ($1.875) = $2.25 The breakeven point is Fixed cost ÷ WACM $33,000 ÷ $2.25 = 14,667 per season 1 100% - state fee of 10% - variable cost of 15% B. The highest number to break even assumes that all admissions are students: $33,000 ÷ $1.875 = 17,600 per season C. The lowest number to break even assumes that all admissions are at the adult rate: $33,000 ÷ $3.75 = 8,800 per season D. Sensitivity analysis can help the analyst model what the results would be if the assumption does not hold true. The analyst could change the sales price and calculate the new break- even point. Likewise, the analyst could change certain cost variables. 2010 CMA Part 2 Practice Answer #6 Risk Management and Capital Budgeting A. The analysis shown below yields the following after-tax incremental cash flows: 1) Period 0 ($13,200,000) 2) Period 1 4,200,000 $ Millions Year Cash Flow Element 0 1 2 3 4 Revenue $16.0 $20.0 $20.0 $20.0 Equipment ($12.0) Equipment Salvage $0.9 Equipment Removal ($1.4) Direct Labor & Materials ($8.0) ($10.0) ($10.0) ($10.0) Indirect Costs ($3.0) ($3.0) ($3.0) ($3.0) Net Working Capital ($1.2) $1.2 Total Cash Flow Before Tax ($13.2) $5.0 $7.0 $7.0 $7.7 Cash Taxes ($0.8) ($1.6) ($1.6) ($1.4) Net Cash Flow, After Tax ($13.2) $4.2 $5.4 $5.4 $6.3 Memo: Calculation of Cash Taxes Tax Profit Before Tax & Depreci- ation $5.0 $7.0 $7.0 $6.5 Tax Depreciation ($3.0) ($3.0) ($3.0) ($3.0) Tax Profit Before Tax $2.0 $4.0 $4.0 $3.5 3) The Period 4 operating cash flow is $5,400,000 calculated as follows. Revenue $20,000,000 Direct labor & material (10,000,000) Indirect costs (3,000,000) Before tax cash flow 7,000,000 Tax effect1 (1,600,000) After tax cash flow $ 5,400,000 1 $7,000,000 - $3,000,000 = $4,000,000 x 40% = ($1,600,000) 2010 CMA Part 2 Practice Answer #6 Risk Management and Capital Budgeting 4) The Period 4 terminal cash flow is $900,000 calculated as follows. Equipment removal ($1,400,000) Salvage 900,000 Working capital recovery 1,200,000 Before tax cash flow 700,000 Tax effect2 200,000 After tax cash flow $ 900,000 2 $700,000 - $1,200,000 = ($500,000) x 40% = $200,000 B. Cash flow variables with potential risks that could affect the estimates made by CAP include the following. • Volume estimates are generally subject to a high degree of estimation error due to the variety of external factors that impact the volume realized in the future. Competitive forces, consumer acceptance of the new product, general economic conditions are just a few of the factors that could influence the ultimate demand realized for the new car by KAC, which would impact the demand for ignition system modules from CAP. Since there are a number of fixed costs, including equipment and indirect costs, deviations in volume could have a significant impact on the cash flows and the financial success of the project. • Exchange rates are another important variable. Since CAP is a U.S. company with a cost structure consisting of U.S. dollar denominated expenses, there is exchange risk resulting from a revenue stream in the Korean Won. The net cash flows from the project in U.S. dollars will be dependent on the exchange rate in effect when each of the KRW denominated payments is received. • Direct costs are another potential variance given that the actual productivity of its workforce, the reliability of its manufacturing systems, and unit materials costs could vary substantially from what CAP projects. In a competitive bidding situation, there may be pressure to bid as low as possible to increase the chances for success. If the firm has used “best case” assumptions for its cost structure, negative variances in the assumptions for direct costs could decrease the amount of cash flow generated from the project relative to expectations. • The estimates for the cost of the equipment removal and the salvage value of the equipment could vary significantly as these costs will occur several years in the future and could negatively impact the expected cash flow. 2010 CMA Part 2 Practice Answer #7 Capital Budgeting A. Net present value of each of the alternatives: Time Amount 14% PV Factor Present Value Vendor A Initial investment 0 $4,000,000 1.000 $4,000,000 Annual cash outflow 1-6 500,000 3.889 1,944,500 NPV $5,944,500 Vendor B Initial investment 0 $1,000,000 1.000 $1,000,000 Replacement 3 1,250,000 0.675 843,750 Annual cash outflow 1-6 750,000 3.889 2,916.750 NPV $4,760,500 Vendor C Annual cash outflow 1-6 $1,400,000 3.889 5,444,600 NPV $5,444,600 B. Ultra Comp should select Vendor B. It is the optimal choice from a financial point of view as it meets the requirements at the lowest cost. Since the decision has already been made to implement a new security system, the issue is to decide on a system that meets the re- quirements at the lowest cost. C. Sensitivity analysis is a tool to test the impact of changing investment assumptions on the resulting net present values. The method helps determine the “sensitivity” of outcomes to changes in the parameters. It shows how the output of the model depends on the input of the model. D. Non-financial factors that Ultra Comp should consider prior to making a recommendation include the following. • Vendor A technology may be more effective in the long term even though it is the highest cost solution. However, there is a risk involved in the fact that this is new technology and may not prove effective. • Vendor B technology is known to be effective and should be satisfactory for the near term. However, there is uncertainty in the long term. • Since Vendor C is a nationally recognized leader, it may be in a better position to man- age the security of Ultra Comp, especially as new developments arise. • Ultra Comp should review the management capability and the financial stability of each of the vendors. • Ultra Comp should contact previous clients of each of the vendors to determine their level of satisfaction with the quality and customer service of each vendor. 2010 CMA Part 2 Practice Answer #8 Ethics A. John will face the following potential issues as he tries to implement an ethics based compliance culture at the new subsidiary: 1) Cross cultural communication issues: John does not have any experience work- ing with people from Corruptia. In addition, the employees of the new subsidiary have limited experience with foreigners. Furthermore, John knows that there have been some conflicts with the distributor in the past regarding Honest Corporation’s business practices. This could be a sign of potential future problems. Finally, the employees of the new subsidiary are proud of their company and their country cul- ture. John will have to be sensitive to these feelings. He will need to be tactful enough to differentiate between legitimate cultural differences and inappropriate business behavior. This combination of facts will make communication especially dif- ficult. 2) Informal control environment: The control environment of the new subsidiary has been based upon informal rules and procedures that were largely dependent upon the founder of the company. This condition will be not acceptable in an environment that is compliant with SOX and FCPA. 3) The company founder: The company founder may not be willing to change his ap- proach to business based upon the requirements of corporate headquarters. Honest Corporation must implement a control environment that is more rules oriented and formalized compared to the environment that the company is used to. The question will be whether the tone at the top of the subsidiary, as communicated by the former founder/