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© copyright 2008 Institute of Management Accountants

These materials are copyrighted and may be reproduced in print form only for use by individual IMA

CMA exam prep product purchasers and authorized CMA Learning System classroom providers. They

may not be used in any way to create derivative works or distributed, reproduced or reused in any

way by anyone not having directly purchased CMA exam prep products from IMA.

Any CMA or CMA candidate who violates these copyright terms without prior authorization from IMA

Professional Development is subject to legal action and will be reported to the ICMA and

immediately expelled from the IMA and CMA program.

It is your responsibility to ensure that any CMA exam prep materials you are using have been

provided to you through authorized channels or personnel. If you are in doubt about the

authenticity of your materials or question the means by which they have been provided to you,

contact IMA customer service at (800) 638-4427 or (201) 573-9000.

INTRODUCTION

The Institute of Management Accountants (IMA™) is publishing this set of CMA Learning

SystemTM challenge practice questions with answers and explanation to help enhance your

preparation for the CMA exams.

The challenge practice questions are multiple-choice questions taken from the Certified

Management Accountant (CMA™) exam question set retired in 2007. All questions in this tool

require calculations and/or advanced analysis, and are therefore considered to be more

challenging than straight forward multiple-choice questions (for example, questions that ask

you to select the best definition for a term). As a general rule, approximately 10-15% of

multiple-choice questions on the CMA exams require calculations and/or advanced analysis in

order to select the correct answer – we call these “challenge” questions. Studying and

understanding these challenge questions will help you gain confidence and experience in

specifically tackling the more difficult questions that appear on the CMA exams.

This tool is intended to supplement your CMA Learning System, CMA Online Intensive Review

and other study materials. To prepare for the Part 3 exam, be sure to read all the Part 3

content in its entirety and study all ICMA Learning Outcome Statements. You should also

spend a sufficient amount of time studying the online practice test questions for Part 3 –

these tests provide specific questions by section and also provide a full emulation of the Part

3 exam. The Challenge Question Practice Tool should be used as an additional method to

specifically study how to deal with challenge questions.

IMPORTANT NOTE: this tool is not representative of an actual Part 3 exam. The

questions in each section are not weighted according to the ICMA content specifications.

Some topics are represented multiple times, while others are not represented at all. All

topics listed in the CMA exam Content Specifications document will be tested on the CMA

exam in the proportions and difficulty levels outlined by the ICMA.

These questions are actual, retired questions from the computer-based CMA exams and have

been taken from the Institute of Certified Management Accountants’ (ICMA) Examination

Questions for Practice documents which were released in 2008 with permission of the ICMA.

TABLE OF CONTENTS

Questions Only...........................................................................................5 - 80

*Note: there are no questions included from Sections A and B because these topics are new to the revised

exam and therefore not included in the ICMA retired question set used as the basis for this tool.

Section C: Corporate Finance (48 question in total) .....................................................5

Topic: Risk and Return ..............................................................................5

Topic: Financial Instruments .......................................................................6

Topic: Cost of Capital ...............................................................................8

Topic: Managing Current Assets.................................................................. 11

Topic: Financing Current Assets ................................................................. 12

Section D: Performance Measurement (52 questions in total) ....................................... 26

Topic: Relevant Data Concepts ................................................................. 26

Topic: Cost/Volume/Profit Analysis............................................................. 26

Topic: Marginal Analysis........................................................................... 43

Topic: Cost-Based Pricing ......................................................................... 51

Section E: Investment Decisions (54 questions in total) ............................................... 61

Topic: Discounted Cash Flow Analysis .......................................................... 53

Topic: Payback and Discounted Payback ....................................................... 69

Topic: Ranking Investment Projects............................................................. 77

Topic: Risk Analysis in Capital Investment ..................................................... 80

Section C: Corporate Finance .............................................................................. 82

Topic: Risk and Return ............................................................................ 82

Topic: Financial Instruments ..................................................................... 83

Topic: Cost of Capital ............................................................................. 84

Topic: Managing Current Assets.................................................................. 88

Topic: Financing Current Assets ................................................................. 88

Section D: Performance Measurement................................................................... 101

Topic: Relevant Data Concepts ................................................................ 101

Topic: Cost/Volume/Profit Analysis............................................................ 101

Topic: Marginal Analysis.......................................................................... 114

Topic: Cost-Based Pricing ........................................................................ 120

Section E: Investment Decisions .......................................................................... 122

Topic: Discounted Cash Flow Analysis ......................................................... 122

Topic: Payback and Discounted Payback ...................................................... 137

Topic: Ranking Investment Projects............................................................ 139

Topic: Risk Analysis in Capital Investment .................................................... 141

IMA CMA Exam Prep Challenge Question Practice Tool

Questions ONLY CMA Part 3 –Strategic Management

Section C: Corporate Finance

Topic: Risk and Return

James Hemming, the chief financial officer of a Midwestern machine parts manufacturer, is

considering splitting the company’s stock, which is currently selling at $80.00 per share. The stock

currently pays a $1.00 per share dividend. If the split is two-for-one, Mr. Hemming may expect the

post split price to be

b. greater than $40.00, if the dividend is changed to $0.45 per new share.

c. greater than $40.00, if the dividend is changed to $0.55 per new share.

d. less than $40.00, regardless of dividend policy.

Topic: Risk and Return

Kalamazoo Inc. has issued 25,000 shares of its authorized 50,000 shares of common stock. There are

5,000 shares of common stock that have been repurchased and are classified as treasury stock.

Kalamazoo has 10,000 shares of preferred stock. If a $0.60 per share dividend has been authorized on

its common stock, what will be the total common stock dividend payment?

a. $12,000.

b. $15,000.

c. $21,000.

d. $30,000.

Topic: Risk and Return

Frasier Products has been growing at a rate of 10% per year and expects this growth to continue and

produce earnings per share of $4.00 next year. The firm has a dividend payout ratio of 35% and a beta

value of 1.25. If the risk-free rate is 7% and the return on the market is 15%, what is the expected

current market value of Frasier’s common stock?

a. $14.00.

b. $16.00.

c. $20.00.

d. $28.00.

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Section C: Corporate Finance

Topic: Financial Instruments

Mason Inc. is considering four alternative opportunities. Required investment outlays and expected

rates of return for these investments are given below.

A $200,000 12.5

B $350,000 14.2

C $570,000 16.5

D $390,000 10.6

The investments will be financed through 40% debt and 60% common equity. Internally generated

funds totaling $1,000,000 are available for reinvestment. If the cost of capital is 11%, and Mason

strictly follows the residual dividend policy, how much in dividends would the company likely pay?

a. $120,000.

b. $328,000.

c. $430,000.

d. $650,000.

Topic: Financial Instruments

Cox Company has sold 1,000 shares of $100 par, 8% preferred stock at an issue price of $92 per share.

Stock issue costs were $5 per share. Cox pays taxes at the rate of 40%. What is Cox’s cost of

preferred stock capital?

a. 8.00%.

b. 8.25%.

c. 8.70%.

d. 9.20%.

Topic: Financial Instruments

Bull & Bear Investment Banking is working with the management of Clark Inc. in order to take the

company public in an initial public offering. Selected financial information for Clark is as follows.

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Section C: Corporate Finance

Common equity: Par value ($1 per share) 3,000,000

Additional paid-in-capital 24,000,000

Retained earnings 6,000,000

Total assets 55,000,000

Net income 3,750,000

Dividend (annual) 1,500,000

If public companies in Clark’s industry are trading at twelve times earnings, what is the estimated

value per share of Clark?

a. $9.00.

b. $12.00.

c. $15.00.

d. $24.00.

Topic: Financial Instruments

Morton Starley Investment Banking is working with the management of Kell Inc. in order to take the

company public in an initial public offering. Selected information for the year just ended for Kell is as

follows.

Common equity: Par value ($1 per share) 3,000,000

Additional paid-in-capital 24,000,000

Retained earnings 6,000,000

Total assets 55,000,000

Net income 3,750,000

Dividend (annual) 1,500,000

If public companies in Kell’s industry are trading at a market to book ratio of 1.5, what is the

estimated value per share of Kell?

a. $13.50.

b. $16.50.

c. $21.50.

d. $27.50.

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Section C: Corporate Finance

Topic: Cost of Capital

The Hatch Sausage Company is projecting an annual growth rate for the foreseeable future of 9%.

The most recent dividend paid was $3.00 per share. New common stock can be issued at $36 per

share. Using the constant growth model, what is the approximate cost of capital for retained earnings?

a. 9.08%.

b. 17.33%.

c. 18.08%

d. 19.88%.

Topic: Cost of Capital

Corporation

Sterling Cooper Warwick Pane

Short-term debt 10% 10% 15% 10%

Long-term debt 40% 35% 30% 30%

Preferred stock 30% 30% 30% 30%

Common equity 20% 25% 25% 30%

a. Sterling.

b. Cooper.

c. Warwick.

d. Pane.

Topic: Cost of Capital

Angela Company’s capital structure consists entirely of long-term debt and common equity. The cost

of capital for each component is shown below.

Long-term debt 8%

Common equity 15%

Angela pays taxes at a rate of 40%. If Angela’s weighted average cost of capital is 10.41%, what

proportion of the company’s capital structure is in the form of long-term debt?

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Section C: Corporate Finance

a. 34%.

b. 45%.

c. 55%.

d. 66%.

Topic: Cost of Capital

The management of Old Fenske Company (OFC) has been reviewing the company’s financing

arrangements. The current financing mix is $750,000 of common stock, $200,000 of preferred stock

($50 par) and $300,000 of debt. OFC currently pays a common stock cash dividend of $2. The

common stock sells for $38, and dividends have been growing at about 10% per year. Debt currently

provides a yield to maturity to the investor of 12%, and preferred stock pays a dividend of 9% to yield

11%. Any new issue of securities will have a flotation cost of approximately 3%. OFC has retained

earnings available for the equity requirement. The company’s effective income tax rate is 40%.

Based on this information, the cost of capital for retained earnings is

a. 9.5%.

b. 14.2%.

c. 15.8%.

d. 16.0%.

Topic: Cost of Capital

An accountant for Stability Inc. must calculate the weighted average cost of capital of the corporation

using the following information.

Interest Rate

Accounts payable $35,000,000 -0-

Long-term debt 10,000,000 8% after-tax

Common stock 10,000,000 18%

Retained earnings 5,000,000 15%

a. 17.00%.

b. 10.36%.

c. 11.50%.

d. 13.40%.

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Section C: Corporate Finance

Topic: Cost of Capital

Kielly Machines Inc. is planning an expansion program estimated to cost $100 million. Kielly is

going to raise funds according to its target capital structure shown below.

Debt .30

Preferred stock .24

Equity .46

Kielly had net income available to common shareholders of $184 million last year of which 75% was

paid out in dividends. The company has a marginal tax rate of 40%.

Additional data:

• The market yield of preferred stock is estimated to be 12%.

• The after-tax cost of retained earnings is estimated to be 16%.

a. 12.22%.

b. 13.00%.

c. 13.54%.

d. 14.00%.

Topic: Cost of Capital

Preferred stock (100,000 shares, 12% dividend) 10,000,000

Common stock (5,000,000 shares outstanding) 60,000,000

Albion’s bonds are currently trading at $1,083.34, reflecting a yield to maturity of 8%. The preferred

stock is trading at $125 per share. Common stock is selling at $16 per share, and Albion’s treasurer

estimates that the firm’s cost of equity is 17%. If Albion’s effective income tax rate is 40%, what is

the firm’s cost of capital?

a. 12.6%.

b. 13.0%.

c. 13.9%.

d. 14.1%.

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Section C: Corporate Finance

Topic: Cost of Capital

Thomas Company’s capital structure consists of 30% long-term debt, 25% preferred stock, and 45%

common equity. The cost of capital for each component is shown below.

Preferred stock 11%

Common equity 15%

If Thomas pays taxes at the rate of 40%, what is the company’s after-tax weighted average cost of

capital?

a. 7.14%.

b. 9.84%.

c. 10.94%.

d. 11.90%.

Topic: Managing Current Assets

Shown below are selected data from Fortune Company’s most recent financial statements.

Accounts receivable 60,000

Inventory 25,000

Supplies 5,000

Accounts payable 40,000

Short-term debt payable 10,000

Accruals 5,000

a. $35,000.

b. $45,000.

c. $50,000.

d. $80,000.

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Section C: Corporate Finance

Topic: Managing Current Assets

A firm uses the following model to determine the optimal average cash balance (Q).

x cost per sale of T-Bill

Q=

interest rate

An increase in which one of the following would result in a decrease in the optimal cash balance?

b. Cost of a security trade.

c. Return on marketable securities.

d. Cash requirements for the year.

Topic: Financing Current Assets

The Rolling Stone Corporation, an entertainment ticketing service, is considering the following means

of speeding cash flow for the corporation.

• Lock Box System. This would cost $25 per month for each of its 170 banks and would result in

interest savings of $5,240 per month.

• Drafts. Drafts would be used to pay for ticket refunds based on 4,000 refunds per month at a

cost of $2.00 per draft, which would result in interest savings of $6,500 per month.

• Bank Float. Bank float would be used for the $1,000,000 in checks written each month. The

bank would charge a 2% fee for this service, but the corporation will earn $22,000 in interest on

the float.

• Electronic Transfer. Items over $25,000 would be electronically transferred; it is estimated that

700 items of this type would be made each month at a cost of $18 each, which would result in

increased interest earnings of $14,000 per month.

Which of these methods of speeding cash flow should Rolling Stone Corporation adopt?

b. Bank float and electronic transfer only.

c. Lock box, drafts, and electronic transfer only.

d. Lock box, bank float, and electronic transfer only.

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Section C: Corporate Finance

Topic: Financing Current Assets

JKL Industries requires its branch offices to transfer cash balances once per week to the central

corporate account. A wire transfer costs $12 and assures the cash is available the same day. A

depository transfer check (DTC) costs $1.50 and generally results in funds being available in 2

days. JKL’s cost of short-term funds averages 9%, and they use a 360-day year in all

calculations. What is the minimum transfer amount that would justify the cost of a wire

transfer as opposed to a DTC?

a. $21,000.

b. $24,000.

c. $27,000.

d. $42,000.

Topic: Financing Current Assets

Clauson Inc. grants credit terms of 1/15, net 30 and projects gross sales for the year of $2,000,000.

The credit manager estimates that 40% of customers pay on the 15th day, 40% of the 30th day and

20% on the 45th day. Assuming uniform sales and a 360-day year, what is the projected amount of

overdue receivables?

a. $50,000.

b. $83,333.

c. $116,676.

d. $400,000.

Topic: Financing Current Assets

Burke Industries has a revolving credit arrangement with its bank which specifies that Burke can

borrow up to $5 million at an annual interest rate of 9% payable monthly. In addition, Burke must pay

a commitment fee of 0.25% per month on the unused portion of the line, payable monthly. Burke

expects to have a $2 million cash balance and no borrowings against this line of credit on April 1, net

cash inflows of $2 million in April, net outflows of $7 million in May, and net inflows of $4 million in

June. If all cash flows occur at the end of the month, approximately how much will Burke pay to the

bank during the second quarter related to this revolving credit arrangement?

a. $47,700.

b. $52,500.

c. $60,200.

d. $62,500.

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Section C: Corporate Finance

Topic: Financing Current Assets

Snug-fit, a maker of bowling gloves, is investigating the possibility of liberalizing its credit policy.

Currently, payment is made on a cash-on-delivery basis. Under a new program, sales would increase

by $80,000. The company has a gross profit margin of 40%. The estimated bad debt loss rate on the

incremental sales would be 6%. Ignoring the cost of money, what would be the return on sales before

taxes for the new sales?

a. 34.0%.

b. 36.2%.

c. 40.0%.

d. 42.5%.

Topic: Financing Current Assets

Foster Products is reviewing its trade credit policy with respect to the small retailers to which it sells.

Four plans have been studied and the results are as follows.

Plan Revenue Debt Costs Receivable Inventory

A $200,000 $ 1,000 $1,000 $20,000 $40,000

B 250,000 3,000 2,000 40,000 50,000

C 300,000 6,000 5,000 60,000 60,000

D 350,000 12,000 8,000 80,000 70,000

The information shows how various annual expenses such as bad debts and the cost of collections

change as sales change. The average balance of accounts receivable and inventory have also been

projected. The cost of the product to Foster is 80% of the selling price, after-tax cost of capital is 15%,

and Foster’s effective income tax rate is 30%. What is the optimal plan for Foster to implement?

a. Plan A.

b. Plan B.

c. Plan C.

d. Plan D.

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Section C: Corporate Finance

Topic: Financing Current Assets

Harson Products currently has a conservative credit policy and is in the process of reviewing three

other credit policies. The current credit policy (Policy A) results in sales of $12 million per year.

Policies B and C involve higher sales, accounts receivable and inventory balances, as well as higher

bad debt and collection costs. Policy D grants longer payment terms than Policy C, but charges

customers interest if they take advantage of the lengthy payment terms. The policies are outlined

below.

P o l i c y (000)

A B C D

Sales $12,000 $13,000 $14,000 $14,000

Average accounts receivable 1,500 2,000 3,500 5,000

Average inventory 2,000 2,300 2,500 2,500

Interest income 0 0 0 500

Bad debt expense 100 125 300 400

Collection cost 100 125 250 350

If the direct cost of products is 80% of sales and the cost of short-term funds is 10%, what is the

optimal policy for Harson?

a. Policy A.

b. Policy B.

c. Policy C.

d. Policy D.

Topic: Financing Current Assets

Locar Corporation had net sales last year of $18,600,000 (of which 20% were installment sales). It

also had an average accounts receivable balance of $1,380,000. Credit terms are 2/10, net 30. Based

on a 360-day year, Locar’s average collection period last year was

a. 26.2 days.

b. 26.7 days.

c. 27.3 days.

d. 33.4 days.

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Section C: Corporate Finance

Topic: Financing Current Assets

Powell Industries deals with customers throughout the country and is attempting to more efficiently

collect its accounts receivable. A major bank has offered to develop and operate a lock-box system for

Powell at a cost of $90,000 per year. Powell averages 300 receipts per day at an average of $2,500

each. Its short-term interest cost is 8% per year. Using a 360-day year, what reduction in average

collection time would be needed in order to justify the lock-box system?

a. 0.67 days.

b. 1.20 days.

c. 1.25 days.

d. 1.50 days.

Topic: Financing Current Assets

Atlantic Distributors is expanding and wants to increase its level of inventory to support an aggressive

sales target. They would like to finance this expansion using debt. Atlantic currently has loan

covenants that require the working capital ratio to be at least 1.2. The average cost of the current

liabilities is 12% and the cost of the long-term debt is 8%. Below is the current balance sheet for

Atlantic.

Fixed assets 100,000 Long-term debt 100,000

Total assets $300,000 Equity 35,000

Total debt & equity $300,000

Which one of the following alternatives will provide the resources to expand the inventory while

lowering the total cost of debt and satisfying the loan covenant?

b. Sell fixed assets with a book value of $20,000 for $25,000 and use the proceeds to increase

inventory.

c. Borrow short-term funds of $25,000, and purchase inventory of $25,000.

d. Collect $25,000 accounts receivable; use $10,000 to purchase inventory and use the balance to

reduce short-term debt.

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Section C: Corporate Finance

Topic: Financing Current Assets

. Valley Inc. uses 400 lbs. of a rare isotope per year. The isotope costs $500 per lb., but the supplier is

offering a quantity discount of 2% for order sizes between 30 and 79 lbs., and a 6% discount for order

sizes of 80 lbs. or more. The ordering costs are $200. Carrying costs are $100 per lb. of material and

are not affected by the discounts. If the purchasing manager places eight orders of 50 lbs. each, the

total cost of ordering and carrying inventory, including discounts lost, will be

a. $1,600.

b. $4,100.

c. $6,600.

d. $12,100.

Topic: Financing Current Assets

A review of the inventories of Cedar Grove Company shows the following cost data for entertainment

centers.

Freight and insurance on shipment 20.00 per unit

Insurance on inventory 15.00 per unit

Unloading 140.00 per order

Cost of placing orders 10.00 per order

Cost of capital 25%

What are the total unit carrying costs of inventory for an entertainment center?

a. $105.

b. $115.

c. $120.

d. $420.

Topic: Financing Current Assets

Paint Corporation expects to use 48,000 gallons of paint per year costing $12 per gallon. Inventory

carrying cost is equal to 20% of the purchase price. The company uses its inventory at a constant rate.

The lead time for placing the order is 3 days, and Paint Corporation holds 2,400 gallons of paint as

safety stock. If the company orders 2,000 gallons of paint per order, what is the cost of carrying

inventory?

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Section C: Corporate Finance

a. $2,400.

b. $5,280.

c. $5,760.

d. $8,160.

Topic: Financing Current Assets

Ferndale Distributors is reviewing its inventory policy with respect to safety stocks of its most popular

product. Four safety stock levels were analyzed and annual stockout costs estimated for each level.

1,000 units $3,000

1,250 units 2,000

1,500 units 1,000

2,000 units 0

The cost of this product is $20 per unit, holding costs are 4% per year, and the cost of short-term funds

is 10% per year. What is the optimal safety stock level?

a. 1,000 units.

b. 1,250 units.

c. 1,500 units.

d. 2,000 units.

Topic: Financing Current Assets

Assume that the following inventory values are determined to be appropriate for Louger Company.

Carrying costs = 20% of inventory value

Purchase price = $10 per unit

Cost per order = $10

a. 45 units.

b. 100 units.

c. 141 units.

d. 1,000 units.

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Section C: Corporate Finance

Topic: Financing Current Assets

The Texas Corporation is considering the following opportunities to purchase an investment at the

following amounts and discounts.

90 days $ 80,000 5%

180 days 75,000 6%

270 days 100,000 5%

360 days 60,000 10%

Which opportunity offers the Texas Corporation the highest annual yield?

a. 90-day investment.

b. 180-day investment.

c. 270-day investment.

d. 360-day investment.

Topic: Financing Current Assets

On June 30 of this year, Mega Bank granted Lang Corporation a $20 million 5-year term loan with a

floating rate of 200 basis points over Treasury Bill rates, payable quarterly. The loan principal is to be

repaid in equal quarterly installments over the term. If Treasury Bills are expected to yield 6% for the

rest of the year, how much will Lang pay to Mega Bank in the last half of this year?

a. $1,800,000.

b. $2,780,000.

c. $2,800,000.

d. $3,170,000.

Topic: Financing Current Assets

Megatech Inc. is a large publicly-held firm. The treasurer is making an analysis of the short-term

financing options available for the third quarter, as the company will need an average of $8 million for

the month of July, $12 million for August, and $10 million for September. The following options are

available.

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Section C: Corporate Finance

million at an effective rate of 7% per year. Any temporarily excess funds will be

deposited in Megatech’s investment account at First City Bank and earn interest at

an annual rate of 4%.

II. Utilize a line of credit from First City Bank with interest accruing monthly on the

amount utilized at the prime rate, which is estimated to be 8% in July and August

and 8.5% in September.

Based on this information, which one of the following actions should the treasurer take?

a. Issue commercial paper, since it is approximately $35,000 less expensive than the line of

credit.

b. Issue commercial paper, since it is approximately $14,200 less expensive than the line of

credit.

c. Use the line of credit, since it is approximately $15,000 less expensive than issuing commercial

paper.

d. Use the line of credit, since it is approximately $5,800 less expensive than issuing commercial

paper.

Topic: Financing Current Assets

Dexter Products receives $25,000 worth of merchandise from its major supplier on the 15th and 30th

of each month. The goods are sold on terms of 1/15, net 45, and Dexter has been paying on the net

due date and foregoing the discount. A local bank offered Dexter a loan at an interest rate of 10%.

What will be the net annual savings to Dexter if it borrows from the bank and utilizes the funds to take

advantage of the trade discount?

a. $525.

b. $1,050.

c. $1,575.

d. $2,250.

Topic: Financing Current Assets

Dudley Products is given terms of 2/10, net 45 by its suppliers. If Dudley forgoes the cash discount

and instead pays the suppliers 5 days after the net due date, what is the annual interest rate cost (using

a 360-day year)?

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Section C: Corporate Finance

a. 18.0%.

b. 18.4%.

c. 21.0%.

d. 24.5%.

Topic: Financing Current Assets

A firm is given payment terms of 3/10, net 90 and forgoes the discount paying on the net due date.

Using a 360-day year and ignoring the effects of compounding, what is the effective annual interest

rate cost?

a. 12.0%.

b. 12.4%.

c. 13.5%.

d. 13.9%.

Topic: Financing Current Assets

Lang National Bank offered a one-year loan to a commercial customer. The instrument is a

discounted note with a nominal rate of 12%. What is the effective interest rate to the borrower?

a. 10.71%.

b. 12.00%.

c. 13.20%.

d. 13.64%.

Topic: Financing Current Assets

Gates Inc. has been offered a one-year loan by its commercial bank. The instrument is a discounted

note with a stated interest rate of 9%. If Gates needs $300,000 for use in the business, what should the

face value of the note be?

a. $275,229.

b. $327,000.

c. $327,154.

d. $329,670.

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Section C: Corporate Finance

Topic: Financing Current Assets

Keller Products needs $150,000 of additional funds over the next year in order to satisfy a significant

increase in demand. A commercial bank has offered Keller a one-year loan at a nominal rate of 8%,

which requires a 15% compensating balance. How much would Keller have to borrow, assuming it

would need to cover the compensating balance with the loan proceeds?

a. $130,435.

b. $172,500.

c. $176,471.

d. $194,805.

Topic: Financing Current Assets

Approximately what amount of compensating balance would be required for a stated interest rate of

10% to equal an effective interest rate of 10.31% on a $100,000,000 one-year loan?

a. $310,000.

b. $3,000,000.

c. $3,100,000.

d. Not enough information is given.

Topic: Financing Current Assets

The effective annual interest rate to the borrower of a $100,000 one-year loan with a stated rate of 7%

and a 20% compensating balance is

a. 7.0%.

b. 8.4%.

c. 8.75%.

d. 13.0%.

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Section C: Corporate Finance

Topic: Financing Current Assets

Todd Manufacturing Company needs a $100 million loan for one year. Todd’s banker has presented

two alternatives as follows:

Option #1 - Loan with a stated interest rate of 10.25%. No compensating balance required.

Option #2 - Loan with a stated interest rate of 10.00%. Non-interest bearing compensating balance

required.

Which of the following compensating balances, withheld from the loan proceeds, would result in

Option #2 having an effective interest rate equal to the 10.25% rate of Option #1?

a. $250,000.

b. $2,440,000.

c. $2,500,000.

d. $10,250,000.

Topic: Financing Current Assets

Frame Industries has arranged a revolving line of credit for the upcoming year with a commercial

bank. The arrangement is for $20 million, with interest payable monthly on the amount utilized at the

bank’s prime rate and an annual commitment fee of one-half of 1 percent, computed and payable

monthly on the unused portion of the line. Frame estimates that the prime rate for the upcoming year

will be 8%, and expects the following average amount to be borrowed by quarter.

First $10,000,000

Second 20,000,000

Third 20,000,000

Fourth 5,000,000

How much will Frame pay to the bank next year in interest and fees?

a. $1,118,750.

b. $1,131,250.

c. $1,168,750.

d. $1,200,000.

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Section C: Corporate Finance

Topic: Financing Current Assets

What is the effective annual interest rate for a one-year $100 million loan with a stated interest rate of

8.00%, if the lending bank requires a non-interest bearing compensating balance in the amount of $5

million?

a. 7.62%

b. 8.00%

c. 8.42%

d. 13.00%

Topic: Financing Current Assets

Garner Products is considering a new accounts payable and cash disbursement process which is

projected to add 3 days to the disbursement schedule without having significant negative effects on

supplier relations. Daily cash outflows average $1,500,000. Garner is in a short-term borrowing

position for 8 months of the year and in an investment position for 4 months. On an annual basis,

bank lending rates are expected to average 7% and marketable securities yields are expected to

average 4%. What is the maximum annual expense that Garner could incur for this new process and

still break even?

a. $90,000.

b. $180,000.

c. $270,000.

d. $315,000.

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Section C: Corporate Finance

Topic: Financing Current Assets

Mandel Inc. has a zero-balance account with a commercial bank. The bank sweeps any excess cash

into a commercial investment account earning interest at the rate of 4% per year, payable monthly.

When Mandel has a cash deficit, a line of credit is used which has an interest rate of 8% per year,

payable monthly based on the amount used. Mandel expects to have a $2 million cash balance on

January 1 of next year. Net cash flows for the first half of the year, excluding the effects of interest

received or paid, are forecasted (in millions of dollars) as follows.

Net cash inflows ($) +2 +1 -5 -3 -2 +6

Assuming all cash-flows occur at the end of each month, approximately how much interest will

Mandel incur for this period?

b. $53,000 net interest paid.

c. $76,000 net interest paid.

d. $195,000 net interest paid.

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Section D: Decision Analysis

Topic: Relevant Data Concepts

Verla Industries is trying to decide which one of the following two options to pursue. Either option

will take effect on January 1st of the next year.

The cost of the machine is $1,000,000 and will have a useful life of five years. Net pre-tax cash flows

arising from savings in labor costs will amount to $100,000 per year for five years. Depreciation

expense will be calculated using the straight-line method for both financial and tax reporting purposes.

As an incentive to purchase, Verla will receive a trade-in allowance of $50,000 on their current fully

depreciated finishing machine.

Verla can outsource the work to LM Inc. at a cost of $200,000 per year for five years. If they

outsource, Verla will scrap their current fully depreciated finishing machine.

Verla’s effective income tax rate is 40%. The weighted-average cost of capital is 10%.

When comparing the two options, the $50,000 trade-in allowance would be considered

b. relevant because it is a decrease in cash outflow.

c. irrelevant because it does not affect cash.

d. relevant because it is an increase in cash outflows.

Topic: Cost/Volume/Profit Analysis

Gardener Company currently is using its full capacity of 25,000 machine hours to manufacture product

XR-2000. LJB Corporation placed an order with Gardener for the manufacture of 1,000 units of KT-

6500. LJB would normally manufacture this component. However, due to a fire at its plant, LJB

needs to purchase these units to continue manufacturing other products. This is a one time special

order. The following reflects unit cost data, and selling prices.

KT-6500 XR-2000

Material $27 $24

Direct labor 12 10

Variable overhead 6 5

Fixed overhead 48 40

Variable selling & administrative 5 4

Fixed selling & administrative 12 10

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Section D: Decision Analysis

What is the minimum unit price that Gardener should charge LJB to manufacture 1,000 units of KT-

6500?

a. $93.00.

b. $96.50.

c. $110.00.

d. $125.00.

Topic: Cost/Volume/Profit Analysis

Following are the operating results of the two segments of Parklin Corporation.

Sales $10,000 $15,000 $25,000

Variable costs of goods sold 4,000 8,500 12,500

Fixed costs of goods sold 1,500 2,500 4,000

Gross margin 4,500 4,000 8,500

Variable selling and administrative 2,000 3,000 5,000

Fixed selling and administrative 1,500 1,500 3,000

Operating income (loss) $ 1,000 $ (500) $ 500

Variable costs of goods sold are directly related to the operating segments. Fixed costs of goods sold

are allocated to each segment based on the number of employees. Fixed selling and administrative

expenses are allocated equally. If Segment B is eliminated, $1,500 of fixed costs of goods sold would

be eliminated. Assuming Segment B is closed, the effect on operating income would be

a. an increase of $500.

b. an increase of $2,000.

c. a decrease of $2,000.

d. a decrease of $2,500.

Topic: Cost/Volume/Profit Analysis

Edwards Products has just developed a new product with a variable manufacturing cost of $30. The

Marketing Director has identified three marketing approaches for this new product.

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Section D: Decision Analysis

Approach X Set a selling price of $36 and have the firm’s sales staff sell the product at a

10% commission with no advertising program. Estimated annual sales would

be 10,000 units.

Approach Y Set a selling price of $38, have the firm’s sales staff sell the product at a 10%

commission, and back them up with a $30,000 advertising program. Estimated

annual sales would be 12,000 units.

Approach Z Rely on wholesalers to handle the product. Edwards would sell the new product

to the wholesalers at $32 per unit and incur no selling expenses. Estimated

annual sales would be 14,000 units.

Rank the three alternatives in order of net contribution, from highest to lowest.

a. X, Y, Z.

b. Y, Z, X.

c. Z, X, Y.

d. Z, Y, X.

Topic: Cost/Volume/Profit Analysis

Parker Manufacturing is analyzing the market potential for its specialty turbines. Parker developed its

pricing and cost structures for their specialty turbines over various relevant ranges. The pricing and

cost data for each relevant range are presented below.

Total fixed costs $200,000 $400,000 $600,000 $800,000

Unit variable cost 50,000 50,000 45,000 45,000

Unit selling price 100,000 100,000 100,000 100,000

Which one of the following production/sales levels would produce the highest operating income for

Parker?

a. 8 units.

b. 10 units.

c. 14 units.

d. 17 units.

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Section D: Decision Analysis

Topic: Cost/Volume/Profit Analysis

Elgers Company produces valves for the plumbing industry. Elgers’ per unit sales price and variable

costs are as follows.

Variable costs 8

Elgers’ practical plant capacity is 40,000 units. Elgers’ total fixed costs aggregate $48,000 and it has a

40% effective tax rate.

a. $48,000.

b. $67,200.

c. $96,000.

d. $112,000.

Topic: Cost/Volume/Profit Analysis

Dayton Corporation manufactures pipe elbows for the plumbing industry. Dayton’s per unit sales

price and variable costs are as follows.

Variable costs 7

Dayton’s practical plant capacity is 35,000 units. Dayton’s total fixed costs amount to $42,000, and

the company has a 50% effective tax rate.

a. $24,000.

b. $45,000.

c. $48,000.

d. $90,000.

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Section D: Decision Analysis

Topic: Cost/Volume/Profit Analysis

Raymund Inc., a bearings manufacturer, has the capacity to produce 7,000 bearings per month. The

company is planning to replace a portion of its labor intensive production process with a highly

automated process, which would increase Raymund’s fixed manufacturing costs by $30,000 per month

and reduce its variable costs by $5 per unit.

Variable manufacturing costs $50,000

Variable selling costs 15,000 65,000

Contribution margin 35,000

Fixed selling costs 4,000 20,000

Operating income $ 15,000

If Raymund installs the automated process, the company’s monthly operating income would be

a. $5,000.

b. $10,000.

c. $30,000.

d. $40,000.

Topic: Cost/Volume/Profit Analysis

Refrigerator Company manufactures ice-makers for installation in refrigerators. The costs per unit, for

20,000 units of ice-makers, are as follows.

Direct materials $ 7

Direct labor 12

Variable overhead 5

Fixed overhead 10

Total costs $34

Cool Compartments Inc. has offered to sell 20,000 ice-makers to Refrigerator Company for $28 per

unit. If Refrigerator accepts Cool Compartments’ offer the plant would be idled and fixed overhead

amounting to $6 per unit could be eliminated. The total relevant costs associated with the manufacture

of ice-makers amount to

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Section D: Decision Analysis

a. $480,000.

b. $560,000.

c. $600,000.

d. $680,000.

Topic: Cost/Volume/Profit Analysis

Phillips and Company produces educational software. Its current unit cost, based upon an anticipated

volume of 150,000 units, is as follows.

Variable costs 60

Contribution margin 90

Fixed costs 60

Operating income 30

Sales for the coming year are estimated at 175,000 units, which is within the relevant range of Phillip’s

cost structure. Cost management initiatives are expected to yield a 20% reduction in variable costs

and a reduction of $750,000 in fixed costs. Phillip’s cost structure for the coming year will include a

b. total contribution margin of $15,300,000 and fixed costs of $8,250,000.

c. variable cost ratio of 32% and operating income of $9,600,000.

d. contribution margin ratio of 68% and operating income of $7,050,000.

Topic: Cost/Volume/Profit Analysis

Sunshine Corporation is considering the purchase of a new machine for $800,000. The machine is

capable of producing 1.6 million units of product over its useful life. The manufacturer’s engineering

specifications state that the machine-related cost of producing each unit of product should be $.50.

Sunshine’s total anticipated demand over the asset’s useful life is 1.2 million units. The average cost

of materials and labor for each unit is $.40. In considering whether to buy the new machine, would

you recommend that Sunshine use the manufacturer’s engineering specification of machine-related

unit production cost?

b. No, the machine-related cost of producing each unit is $.67.

c. No, the machine-related cost of producing each unit is $.90.

d. Yes, the machine-related cost of producing each unit is $.50.

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Section D: Decision Analysis

Topic: Cost/Volume/Profit Analysis

Cervine Corporation makes two types of motors for use in various products. Operating data and unit

cost information for its products are presented below.

Product A Product B

Variable manufacturing cost 53 45

Fixed manufacturing cost 10 10

Variable selling & administrative 10 11

Fixed selling & administrative 5 4

Fixed other administrative 2 0

Unit operating profit $ 20 $10

Cervine has 40,000 productive machine hours available. The relevant contribution margins, per

machine hour for each product, to be utilized in making a decision on product priorities for the coming

year, are

Product A Product B

a. $17.00 $14.00.

b. $18.50 $16.00.

c. $20.00 $10.00.

d. $37.00 $24.00.

Topic: Cost/Volume/Profit Analysis

Two months ago, Hickory Corporation purchased 4,500 pounds of Kaylene at a cost of $15,300. The

market for this product has become very strong, with the price jumping to $4.05 per pound. Because

of the demand, Hickory can buy or sell Kaylene at this price. Hickory recently received a special

order inquiry that would require the use of 4,200 pounds of Kaylene. In deciding whether to accept

the order, management must evaluate a number of decision factors. Without regard to income taxes,

which one of the following combination of factors correctly depicts relevant and irrelevant decision

factors, respectively?

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Section D: Decision Analysis

a. Remaining 300 pounds of Kaylene Market price of $4.05 per lb.

b. Market price of $4.05 per lb. Purchase price of $3.40 per lb.

c. Purchase price of $3.40 per lb. Market price of $4.05 per lb.

d. 4,500 pounds of Kaylene Remaining 300 pounds of Kaylene.

Topic: Cost/Volume/Profit Analysis

Reynolds Inc. manufactures several different products, including a premium lawn fertilizer and weed

killer that is popular in hot, dry climates. Reynolds is currently operating at less than full capacity

because of market saturation for lawn fertilizer. Sales and cost data for a 40-pound bag of Reynolds

lawn fertilizer is as follows.

Production cost

Materials and labor $12.25

Variable overhead 3.75

Allocated fixed overhead 4.00 20.00

Income (loss) per bag $(1.50)

On the basis of this information, which one of the following alternatives should be recommended to

Reynolds management?

b. Drop this product from its product line.

c. Continue to produce and market this product.

d. Increase output and spread fixed overhead over a larger volume base.

Topic: Cost/Volume/Profit Analysis

Capital Company has decided to discontinue a product produced on a machine purchased four years

ago at a cost of $70,000. The machine has a current book value of $30,000. Due to technologically

improved machinery now available in the marketplace the existing machine has no current salvage

value. The company is reviewing the various aspects involved in the production of a new product.

The engineering staff advised that the existing machine can be used to produce the new product.

Other costs involved in the production of the new product will be materials of $20,000 and labor

priced at $5,000.

Ignoring income taxes, the costs relevant to the decision to produce or not to produce the new product

would be

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Section D: Decision Analysis

a. $25,000.

b. $30,000.

c. $55,000.

d. $95,000.

Topic: Cost/Volume/Profit Analysis

Allred Company sells its single product for $30 per unit. The contribution margin ratio is 45%, and

fixed costs are $10,000 per month. Allred has an effective income tax rate of 40%. If Allred sells

1,000 units in the current month, Allred’s variable expenses would be

a. $9,900.

b. $12,000.

c. $13,500.

d. $16,500.

Topic: Cost/Volume/Profit Analysis

Phillips & Company produces educational software. Its unit cost structure, based upon an anticipated

production volume of 150,000 units, is as follows.

Variable costs 60

Fixed costs 55

The marketing department has estimated sales for the coming year at 175,000 units, which is within

the relevant range of Phillip’s cost structure. Phillip’s break-even volume (in units) and anticipated

operating income for the coming year would amount to

b. 82,500 units and $9,250,000 of operating income.

c. 96,250 units and $3,543,750 of operating income.

d. 96,250 units and $7,875,000 of operating income.

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Section D: Decision Analysis

Topic: Cost/Volume/Profit Analysis

Jeffries Company sells its single product for $30 per unit. The contribution margin ratio is 45%, and

fixed costs are $10,000 per month. Sales were 3,000 units in April and 4,000 units in May. How

much greater is the May operating income than the April operating income?

a. $10,000.

b. $13,500.

c. $16,500.

d. $30,000.

Topic: Cost/Volume/Profit Analysis

Cervine Corporation makes motors for various products. Operating data and unit cost information for

its products are presented below.

Product A Product B

Variable manufacturing cost 53 45

Fixed manufacturing cost 10 10

Variable selling & administrative 10 11

Fixed selling & administrative 5 4

Fixed other administrative 2 -

Unit operating profit $ 20 $10

Cervine has 40,000 productive machine hours available. What is the maximum total contribution

margin that Cervine can generate in the coming year?

a. $665,000.

b. $689,992

c. $850,000.

d. $980,000.

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Section D: Decision Analysis

Topic: Cost/Volume/Profit Analysis

Lazar Industries produces two products, Crates and Trunks. Per unit selling prices, costs, and resource

utilization for these products are as follows.

Crates Trunks

Selling price $20 $30

Direct material costs $ 5 $ 5

Direct labor costs 8 10

Variable overhead costs 2 5

Variable selling costs 1 2

Production of Crates and Trunks involves joint processes and use of the same facilities. The total

fixed factory overhead cost is $2,000,000 and total fixed selling and administrative costs are $840,000.

Production and sales are scheduled for 500,000 Crates and 700,000 Trunks. Lazar has a normal

capacity to produce a total of 2,000,000 units in any combination of Crates and Trunks, and maintains

no direct materials, work-in-process, or finished goods inventory.

Due to plant renovations Lazar Industries will be limited to 1,000,000 machine hours. What is the

maximum amount of contribution margin Lazar can generate during the renovation period?

a. $1,500,000.

b. $2,000,000.

c. $3,000,000.

d. $7,000,000.

Topic: Cost/Volume/Profit Analysis

For the year just ended, Silverstone Company’s sales revenue was $450,000. Silverstone’s fixed costs

were $120,000 and its variable costs amounted to $270,000. For the current year sales are forecasted

at $500,000. If the fixed costs do not change, Silverstone’s operating profits this year will be

a. $60,000.

b. $80,000.

c. $110,000.

d. $200,000.

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Section D: Decision Analysis

Topic: Cost/Volume/Profit Analysis

Breeze Company has a contribution margin of $4,000 and fixed costs of $1,000. If the total

contribution margin increases by $1,000, operating profit would

a. decrease by $1,000.

b. increase by more than $1,000.

c. increase by $1,000.

d. remain unchanged.

Topic: Cost/Volume/Profit Analysis

Wilkinson Company sells its single product for $30 per unit. The contribution margin ratio is 45%

and Wilkinson has fixed costs of $10,000 per month. If 3,000 units are sold in the current month,

Wilkinson’s operating profit would be

a. $30,500.

b. $49,500.

c. $40,500.

d. $90,000.

Topic: Cost/Volume/Profit Analysis

Starlight Theater stages a number of summer musicals at its theater in northern Ohio. Preliminary

planning has just begun for the upcoming season, and Starlight has developed the following estimated

data.

Average

Number of Attendance per Ticket Variable Fixed

Production Performances Performance Price Costs 1 Costs 2

Mr. Wonderful 12 3,500 $18 $3 $165,000

That’s Life 20 3,000 15 1 249,000

All That Jazz 12 4,000 20 0 316,000

1

Represent payments to production companies and are based on tickets sold.

2

Costs directly associated with the entire run of each production for costumes, sets, and

artist fees.

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Section D: Decision Analysis

Starlight will also incur $565,000 of common fixed operating charges (administrative overhead,

facility costs, and advertising) for the entire season, and is subject to a 30% income tax rate.

If Starlight’s schedule of musicals is held, as planned, how many patrons would have to attend for

Starlight to break even during the summer season?

a. 77,918.

b. 79,302.

c. 79,939

d. 81,344.

Topic: Cost/Volume/Profit Analysis

Carson Inc. manufactures only one product and is preparing its budget for next year based on the

following information.

Variable costs per unit 75

Fixed costs 250,000

Effective tax rate 35%

If Carson wants to achieve a net income of $1.3 million next year, its sales must be

a. 62,000 units.

b. 70,200 units.

c. 80,000 units.

d. 90,000 units.

Topic: Cost/Volume/Profit Analysis

MetalCraft produces three inexpensive socket wrench sets that are popular with do-it-yourselfers.

Budgeted information for the upcoming year is as follows.

Estimated

Model Selling Price Variable Cost Sales Volume

No. 109 $10.00 $ 5.50 30,000 sets

No. 145 15.00 8.00 75,000 sets

No. 153 20.00 14.00 45,000 sets

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Section D: Decision Analysis

Total fixed costs for the socket wrench product line is $961,000. If the company’s actual experience

remains consistent with the estimated sales volume percentage distribution, and the firm desires to

generate total operating income of $161,200, how many Model No. 153 socket sets will MetalCraft

have to sell?

a. 26,000.

b. 54,300.

c. 155,000.

d. 181,000.

Topic: Cost/Volume/Profit Analysis

Robin Company wants to earn a 6% return on sales after taxes. The company’s effective income tax

rate is 40%, and its contribution margin is 30%. If Robin has fixed costs of $240,000, the amount of

sales required to earn the desired return is

a. $375,000.

b. $400,000.

c. $1,000,000.

d. $1,200,000.

Topic: Cost/Volume/Profit Analysis

Bargain Press is considering publishing a new textbook. The publisher has developed the following

cost data related to a production run of 6,000, the minimum possible production run. Bargain Press

will sell the textbook for $45 per copy. How many textbooks must Bargain Press sell in order to

generate operating earnings (earnings before interest and taxes) of 20% on sales? (Round your answer

up to the nearest whole textbook.)

Estimated cost

Development (reviews, class testing, editing) $35,000

Typesetting 18,500

Depreciation on Equipment 9,320

General and Administrative 7,500

Miscellaneous Fixed Costs 4,400

Printing and Binding 30,000

Sales staff commissions (2% of selling price) 5,400

Bookstore commissions (25% of selling price) 67,500

Author’s Royalties (10% of selling price) 27,000

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Section D: Decision Analysis

a. 2,076 copies.

b. 5,207 copies.

c. 5,412 copies.

d. 6,199 copies.

Topic: Cost/Volume/Profit Analysis

Zipper Company invested $300,000 in a new machine to produce cones for the textile industry.

Zipper’s variable costs are 30% of the selling price, and its fixed costs are $600,000. Zipper has an

effective income tax rate of 40%. The amount of sales required to earn an 8% after-tax return on its

investment would be

a. $891,429.

b. $914,286.

c. $2,080,000.

d. $2,133,333.

Topic: Cost/Volume/Profit Analysis

Starlight Theater stages a number of summer musicals at its theater in northern Ohio. Preliminary

planning has just begun for the upcoming season, and Starlight has developed the following estimated

data.

Average

Number of Attendance per Ticket Variable Fixed

Production Performances Performance Price Costs1 Costs 2

Mr. Wonderful 12 3,500 $18 $3 $165,000

That’s Life 20 3,000 15 1 249,000

All That Jazz 12 4,000 20 0 316,000

1

Represent payments to production companies and are based on tickets sold.

2

Costs directly associated with the entire run of each production for costumes, sets, and

artist fees.

Starlight will also incur $565,000 of common fixed operating charges (administrative overhead,

facility costs, and advertising) for the entire season, and is subject to a 30% income tax rate.

If management desires Mr. Wonderful to produce an after-tax contribution of $210,000 toward the

firm’s overall operating income for the year, total attendance for the production would have to be

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Section D: Decision Analysis

a. 20,800.

b. 25,000.

c. 25,833.

d. 31,000.

Topic: Cost/Volume/Profit Analysis

Specialty Cakes Inc. produces two types of cakes, a 2 lbs. round cake and a 3 lbs. heart-shaped cake.

Total fixed costs for the firm are $94,000. Variable costs and sales data for the two types of cakes are

presented below.

2 lbs. 3 lbs.

Round Cake Heart-shape Cake

Selling price per unit $12 $20

Variable cost per unit $8 $15

Current sales (units) 10,000 15,000

If the product sales mix were to change to three heart-shaped cakes for each round cake, the breakeven

volume for each of these products would be

b. 12,261 round cakes, 8,174 heart-shaped cakes.

c. 4,948 round cakes, 14,843 heart-shaped cakes.

d. 15,326 round cakes, 8,109 heart-shaped cakes.

Topic: Cost/Volume/Profit Analysis

Eagle Brand Inc. produces two products. Data regarding these products are presented below.

Product X Product Y

Selling price per unit $100 $130

Variable costs per unit $80 $100

Raw materials used per unit 4 lbs. 10 lbs.

Eagle Brand has 1,000 lbs. of raw materials which can be used to produce Products X and Y.

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Section D: Decision Analysis

Which one of the alternatives below should Eagle Brand accept in order to maximize contribution

margin?

b. 250 units of product X.

c. 200 units of product X and 20 units of product Y.

d. 200 units of product X and 50 units of product Y.

Topic: Cost/Volume/Profit Analysis

Oakes Inc. manufactured 40,000 gallons of Mononate and 60,000 gallons of Beracyl in a joint

production process, incurring $250,000 of joint costs. Oakes allocates joint costs based on the

physical volume of each product produced. Mononate and Beracyl can each be sold at the split-off

point in a semifinished state or, alternatively, processed further. Additional data about the two

products are as follows.

Mononate Beracyl

Sales price per gallon at split-off $7 $15

Sales price per gallon if processed further $10 $18

Variable production costs if processed further $125,000 $115,000

An assistant in the company’s cost accounting department was overheard saying “....that when both

joint and separable costs are considered, the firm has no business processing either product beyond the

split-off point. The extra revenue is simply not worth the effort.” Which of the following strategies

should be recommended for Oakes?

Mononate Beracyl

a. Sell at split-off Sell at split-off.

b. Sell at split-off Process further.

c. Process further Sell at split-off.

d. Process further Process further.

Topic: Cost/Volume/Profit Analysis

Current business segment operations for Whitman, a mass retailer, are presented below.

Merchandise Automotive Restaurant Total

Sales $500,000 $400,000 $100,000 $1,000,000

Variable costs 300,000 200,000 70,000 570,000

Fixed costs 100,000 100,000 50,000 250,000

Operating income (loss) $100,000 $100,000 $(20,000) $ 180,000

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Section D: Decision Analysis

Management is contemplating the discontinuance of the Restaurant segment since “it is losing

money.” If this segment is discontinued, $30,000 of its fixed costs will be eliminated. In addition,

Merchandise and Automotive sales will decrease 5% from their current levels. What will Whitman’s

total contribution margin be if the Restaurant segment is discontinued?

a. $160,000.

b. $220,000.

c. $367,650.

d. $380,000.

Topic: Cost/Volume/Profit Analysis

Current business segment operations for Whitman, a mass retailer, are presented below.

Merchandise Automotive Restaurant Total

Sales $500,000 $400,000 $100,000 $1,000,000

Variable costs 300,000 200,000 70,000 570,000

Fixed costs 100,000 100,000 50,000 250,000

Operating income (loss) $100,000 $100,000 $ (20,000) $ 180,000

Management is contemplating the discontinuance of the Restaurant segment since “it is losing

money.” If this segment is discontinued, $30,000 of its fixed costs will be eliminated. In addition,

Merchandise and Automotive sales will decrease 5% from their current levels. When considering the

decision, Whitman’s controller advised that one of the financial aspects Whitman should review is

contribution margin. Which one of the following options reflects the current contribution margin

ratios for each of Whitman’s business segments?

a. 60% 50% 30%.

b. 60% 50% 70%.

c. 40% 50% 70%.

d. 40% 50% 30%.

Topic: Marginal Analysis

Aril Industries is a multi-product company that currently manufactures 30,000 units of Part 730 each

month for use in production. The facilities now being used to produce Part 730 have fixed monthly

overhead costs of $150,000, and a theoretical capacity to produce 60,000 units per month. If Aril were

to buy Part 730 from an outside supplier, the facilities would be idle and 40% of fixed costs would

continue to be incurred. There are no alternative uses for the facilities. The variable production costs

of Part 730 are $11 per unit. Fixed overhead is allocated based on planned production levels.

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Section D: Decision Analysis

If Aril Industries continues to use 30,000 units of Part 730 each month, it would realize a net benefit

by purchasing Part 730 from an outside supplier only if the supplier’s unit price is less than

a. $12.00.

b. $12.50.

c. $13.00.

d. $14.00.

Topic: Marginal Analysis

Lark Industries accepted a contract to provide 30,000 units of Product A and 20,000 units of Product

B. Lark’s staff developed the following information with regard to meeting this contract.

Selling Price $75 $125

Variable costs $30 $48

Fixed overhead $1,600,000

Machine hours required 3 5

Machine hours available 160,000

Cost if outsourced $45 $60

Lark’s operations manager has identified the following alternatives. Which alternative should be

recommended to Lark’s management?

a. Make 30,000 units of Product A, utilize the remaining capacity to make Product B, and

outsource the remainder.

b. Make 25,000 units of Product A, utilize the remaining capacity to make Product B, and

outsource the remainder.

c. Make 20,000 units of Product A, utilize the remaining capacity to make Product B, and

outsource the remainder.

d. Rent additional capacity of 30,000 machine hours which will increase fixed costs by $150,000.

Topic: Marginal Analysis

Raymund Inc. currently sells its only product to Mall-Stores. Raymund has received a one-time-only

order for 2,000 units from another buyer. Sale of the special order items will not require any

additional selling effort. Raymund has a manufacturing capacity to produce 7,000 units. Raymund

has an effective income tax rate of 40%. Raymund’s Income Statement, before consideration of the

one-time-only order, is as follows.

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Section D: Decision Analysis

Variable manufacturing costs $50,000

Variable selling costs 15,000 65,000

Contribution margin 35,000

Fixed selling costs 4,000 20,000

Operating income 15,000

Net income $ 9,000

In negotiating a price for the special order, Raymund should set the minimum per unit selling price at

a. $10.

b. $13.

c. $17.

d. $18.

Topic: Marginal Analysis

The Furniture Company currently has three divisions: Maple, Oak, and Cherry. The oak furniture line

does not seem to be doing well and the president of the company is considering dropping this line. If

it is dropped, the revenues associated with the Oak Division will be lost and the related variable costs

saved. Also, 50% of the fixed costs allocated to the oak furniture line would be eliminated. The

income statements, by divisions, are as follows.

Sales $55,000 $85,000 $100,000

Variable Costs 40,000 72,000 82,000

Contribution Margin 15,000 13,000 18,000

Fixed costs 10,000 14,000 10,200

Operating profit (loss) $ 5,000 $(1,000) $ 7,800

Which one of the following options should be recommended to the president of the company?

a. Continue operating the Oak Division as discontinuance would result in a total operating loss of

$1,200.

b. Continue operating the Oak Division as discontinuance would result in a $6,000 decline in

operating profits.

c. Discontinue the Oak Division which would result in a $1,000 increase in operating profits.

d. Discontinue the Oak Division which would result in a $7,000 increase in operating profits.

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Section D: Decision Analysis

Topic: Marginal Analysis

Aspen Company plans to sell 12,000 units of product XT and 8,000 units of product RP. Aspen has a

capacity of 12,000 productive machine hours. The unit cost structure and machine hours required for

each product is as follows.

Unit Costs XT RP

Materials $37 $24

Direct labor 12 13

Variable overhead 6 3

Fixed overhead 37 38

Aspen can purchase 12,000 units of XT at $60 and/or 8,000 units of RP at $45. Based on the above,

which one of the following actions should be recommended to Aspen's management?

b. Produce RP internally and purchase XT.

c. Purchase both XT and RP.

d. Produce both XT and RP.

Topic: Marginal Analysis

Refrigerator Company manufactures ice-makers for installation in refrigerators. The costs per unit, for

20,000 units of ice-makers, are as follows.

Direct materials $ 7

Direct labor 12

Variable overhead 5

Fixed overhead 10

Total costs $34

Cool Compartments Inc. has offered to sell 20,000 ice-makers to Refrigerator Company for $28 per

unit. If Refrigerator accepts Cool Compartments’ offer, the facilities used to manufacture ice-makers

could be used to produce water filtration units. Revenues from the sale of water filtration units are

estimated at $80,000, with variable costs amounting to 60% of sales. In addition, $6 per unit of the

fixed overhead associated with the manufacture of ice-makers could be eliminated.

For Refrigerator Company to determine the most appropriate action to take in this situation, the total

relevant costs of make vs. buy, respectively, are

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Section D: Decision Analysis

b. $648,000 vs. $528,000.

c. $632,000 vs. $560,000.

d. $680,000 vs. $440,000.

Topic: Marginal Analysis

Lazar Industries produces two products, Crates and Boxes. Per unit selling prices, costs, and resource

utilization for these products are as follows.

Crates Boxes

Selling price $20 $30

Direct material costs $ 5 $ 5

Direct labor costs 8 10

Variable overhead costs 3 5

Variable selling costs 1 2

Production of Crates and Boxes involves joint processes and use of the same facilities. The total fixed

factory overhead cost is $2,000,000 and total fixed selling and administrative costs are $840,000.

Production and sales are scheduled for 500,000 units of Crates and 700,000 units of Boxes. Lazar

maintains no direct materials, work-in-process, or finished goods inventory.

Lazar can reduce direct material costs for Crates by 50% per unit, with no change in direct labor costs.

However, it would increase machine-hour production time by 1-1/2 hours per unit. For Crates,

variable overhead costs are allocated based on machine hours. What would be the effect on the total

contribution margin if this change were to be implemented?

a. $125,000 increase.

b. $250,000 decrease.

c. $300,000 increase.

d. $1,250,000 increase.

Topic: Marginal Analysis

Basic Computer Company (BCC) sells its micro-computers using bid pricing. It develops bids on a

full cost basis. Full cost includes estimated material, labor, variable overheads, fixed manufacturing

overheads, and reasonable incremental computer assembly administrative costs, plus a 10% return on

full cost. BCC believes bids in excess of $925 per computer are not likely to be considered.

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Section D: Decision Analysis

BCC’s current cost structure, based on its normal production levels, is $500 for materials per computer

and $20 per labor hour. Assembly and testing of each computer requires 12 labor hours. BCC’s

variable manufacturing overhead is $2 per labor hour, fixed manufacturing overhead is $3 per labor

hour, and incremental administrative costs are $8 per computer assembled.

The company has received a request from the School Board for 500 computers. BCC’s management

expects heavy competition in bidding for this job. As this is a very large order for BCC, and could

lead to other educational institution orders, management is extremely interested in submitting a bid

which would win the job, but at a price high enough so that current net income will not be unfavorably

impacted. Management believes this order can be absorbed within its current manufacturing facility.

Which one of the following bid prices should be recommended to BCC’s management?

a. $764.00.

b. $772.00.

c. $849.20.

d. $888.80.

Topic: Marginal Analysis

Jones Enterprises manufactures 3 products, A, B, and C. During the month of May Jones’ production,

costs, and sales data were as follows.

Products

A B C Totals

Units of production 30,000 20,000 70,000 120,000

Joint production costs

to split-off point $480,000

Further processing costs $ - $60,000 $140,000

Unit sales price

At split-off 3.75 5.50 10.25

After further processing - 8.00 12.50

Based on the above information, which one of the following alternatives should be recommended to

Jones’ management?

b. Process Product B further but sell Product C at the split-off point.

c. Process Product C further but sell Product B at the split-off point.

d. Process both Products B and C further.

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Section D: Decision Analysis

Topic: Marginal Analysis

Synergy Inc. produces a component that is popular in many refrigeration systems. Data on three of the

five different models of this component are as follows.

Model

A B C

Volume needed (units) 5,000 6,000 3,000

Manufacturing costs

Variable direct costs $10 $24 $20

Variable overhead 5 10 15

Fixed overhead 11 20 17

Total manufacturing costs $26 $54 $52

Synergy applies variable overhead on the basis of machine hours at the rate of $2.50 per hour. Models

A and B are manufactured in the Freezer Department, which has a capacity of 28,000 machine

processing hours. Which one of the following options should be recommended to Synergy's

management?

b. Manufacture all three products in the quantities required.

c. The Freezer Department's manufacturing plan should include 5,000 units of Model A and

4,500 units of Model B.

d. The Freezer Department's manufacturing plan should include 2,000 units of Model A and

6,000 units of Model B.

Topic: Marginal Analysis

The Doll House, a very profitable company, plans to introduce a new type of doll to its product line.

The sales price and costs for the new dolls are as follows.

Variable cost per doll $60

Incremental annual fixed costs $456,000

Income tax rate 30%

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Section D: Decision Analysis

If 10,000 new dolls are produced and sold, the effect on Doll House’s profit (loss) would be

a. $(176,000).

b. $(56,000).

c. $(39,200).

d. $280,000.

Topic: Marginal Analysis

Johnson Company manufactures a variety of shoes, and has received a special one-time-only order

directly from a wholesaler. Johnson has sufficient idle capacity to accept the special order to

manufacture 15,000 pairs of sneakers at a price of $7.50 per pair. Johnson’s normal selling price is

$11.50 per pair of sneakers. Variable manufacturing costs are $5.00 per pair and fixed manufacturing

costs are $3.00 a pair. Johnson’s variable selling expense for its normal line of sneakers is $1.00 per

pair. What would the effect on Johnson’s operating income be if the company accepted the special

order?

a. Decrease by $60,000.

b. Increase by $22,500.

c. Increase by $37,500.

d. Increase by $52,500.

Topic: Marginal Analysis

The Robo Division, a decentralized division of GMT Industries, has been approached to submit a bid

for a potential project for the RSP Company. Robo Division has been informed by RSP that they will

not consider bids over $8,000,000. Robo Division purchases its materials from the Cross Division of

GMT Industries. There would be no additional fixed costs for either the Robo or Cross Divisions.

Information regarding this project is as follows.

Variable Costs $1,500,000 $4,800,000

Transfer Price 3,700,000 -

If Robo Division submits a bid for $8,000,000, the amount of contribution margin recognized by the

Robo Division and GMT Industries, respectively, is

b. $3,200,000 and $(500,000).

c. $(500,000) and $1,700,000.

d. $3,200,000 and $1,700.000.

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Section D: Decision Analysis

Topic: Cost-Based Pricing

Leader Industries is planning to introduce a new product, DMA. It is expected that 10,000 units of

DMA will be sold. The full product cost per unit is $300. Invested capital for this product amounts to

$20 million. Leader’s target rate of return on investment is 20%. The markup percentage for this

product, based on operating income as a percentage of full product cost, will be

a. 42.9%.

b. 57.1%.

c. 133.3%.

d. 233.7%.

Topic: Cost-Based Pricing

Basic Computer Company (BCC) sells its microcomputers using bid pricing. It develops its bids on a

full cost basis. Full cost includes estimated material, labor, variable overheads, fixed manufacturing

overheads, and reasonable incremental computer assembly administrative costs, plus a 10% return on

full cost. BCC believes bids in excess of $1,050 per computer are not likely to be considered.

BCC’s current cost structure, based on its normal production levels, is $500 for materials per computer

and $20 per labor hour. Assembly and testing of each computer requires 17 labor hours. BCC expects

to incur variable manufacturing overhead of $2 per labor hour, fixed manufacturing overhead of $3 per

labor hour, and incremental administrative costs of $8 per computer assembled.

BCC has received a request from a school board for 200 computers. Using the full-cost criteria and

desired level of return, which one of the following prices should be recommended to BCC’s

management for bidding purposes?

a. $874.00.

b. $882.00.

c. $961.40.

d. $1,026.30.

Topic: Cost-Based Pricing

Almelo Manpower Inc. provides contracted bookkeeping services. Almelo has annual fixed costs of

$100,000 and variable costs of $6 per hour. This year the company budgeted 50,000 hours of

bookkeeping services. Almelo prices its services at full cost and uses a cost-plus pricing approach.

The company developed a billing price of $9 per hour. The company’s mark-up level would be

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Section D: Decision Analysis

a. 12.5%.

b. 33.3%.

c. 50.0%.

d. 66.6%.

Topic: Cost-Based Pricing

Fennel Products is using cost-based pricing to determine the selling price for its new product based on

the following information.

Fixed costs $700,000 per year

Variable costs $200 per unit

Plant investment $3,000,000

Working capital $1,000,000

Effective tax rate 40%

The target price that Fennell needs to set for the new product to achieve a 15% after-tax return on

investment (ROI) would be

a. $228.

b. $238.

c. $258.

d. $268.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

Calvin Inc. is considering the purchase of a new state-of-art machine to replace its hand-operated

machine. Calvin’s effective tax rate is 40%, and its cost of capital is 12%. Data regarding the existing

and new machines are presented below.

Existing New

Machine Machine

Original cost $50,000 $90,000

Installation costs 0 4,000

Freight and insurance 0 6,000

Expected end salvage value 0 0

Depreciation method straight-line straight-line

Expected useful life 10 years 5 years

The existing machine has been in service for seven years and could be sold currently for $25,000.

Calvin expects to realize a before-tax annual reduction in labor costs of $30,000 if the new machine is

purchased and placed in service.

If the new machine is purchased, the incremental cash flows for the fifth year would amount to

a. $18,000.

b. $24,000.

c. $26,000.

d. $30,000.

Topic: Discounted Cash Flow Analysis

Olson Industries needs to add a small plant to accommodate a special contract to supply building

materials over a five year period. The required initial cash outlays at Time 0 are as follows.

Land $ 500,000

New building 2,000,000

Equipment 3,000,000

Olson uses straight-line depreciation for tax purposes and will depreciate the building over 10 years

and the equipment over 5 years. Olson’s effective tax rate is 40%.

Revenues from the special contract are estimated at $1.2 million annually, and cash expenses are

estimated at $300,000 annually. At the end of the fifth year, the assumed sales values of the land and

building are $800,000 and $500,000, respectively. It is further assumed the equipment will be

removed at a cost of $50,000 and sold for $300,000.

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Section E: Investment Decisions

As Olson utilizes the net present value (NPV) method to analyze investments, the net cash flow for

period 3 would be

a. $60,000.

b. $860,000.

c. $880,000.

d. $940,000.

Topic: Discounted Cash Flow Analysis

The following schedule reflects the incremental costs and revenues for a capital project. The company

uses straight-line depreciation. The interest expense reflects an allocation of interest on the amount of

this investment, based on the company’s weighted average cost of capital.

Revenues $650,000

Direct costs $270,000

Variable overhead 50,000

Fixed overhead 20,000

Depreciation 70,000

General & administrative 40,000

Interest expense 8,000

Total costs 458,000

Net profit before taxes $192,000

The annual cash flow from this investment, before tax considerations, would be

a. $192,000.

b. $200,000.

c. $262,000.

d. $270,000.

Topic: Discounted Cash Flow Analysis

Kell Inc. is analyzing an investment for a new product expected to have annual sales of 100,000 units

for the next 5 years and then be discontinued. New equipment will be purchased for $1,200,000 and

cost $300,000 to install. The equipment will be depreciated on a straight-line basis over 5 years for

financial reporting purposes and 3 years for tax purposes. At the end of the fifth year, it will cost

$100,000 to remove the equipment, which can be sold for $300,000. Additional working capital of

$400,000 will be required immediately and needed for the life of the product. The product will sell for

$80, with direct labor and material costs of $65 per unit. Annual indirect costs will increase by

$500,000. Kell’s effective tax rate is 40%.

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Section E: Investment Decisions

In a capital budgeting analysis, what is the expected cash flow at time = 5 (fifth year of operations)

that Kell should use to compute the net present value?

a. $720,000.

b. $800,000.

c. $1,120,000.

d. $1,240,000.

Topic: Discounted Cash Flow Analysis

Kell Inc. is analyzing an investment for a new product expected to have annual sales of 100,000 units

for the next 5 years and then be discontinued. New equipment will be purchased for $1,200,000 and

cost $300,000 to install. The equipment will be depreciated on a straight-line basis over 5 years for

financial reporting purposes and 3 years for tax purposes. At the end of the fifth year, it will cost

$100,000 to remove the equipment, which can be sold for $300,000. Additional working capital of

$400,000 will be required immediately and needed for the life of the product. The product will sell for

$80, with direct labor and material costs of $65 per unit. Annual indirect costs will increase by

$500,000. Kell’s effective tax rate is 40%.

In a capital budgeting analysis, what is the cash flow at time 0 (initial investment) that Kell should use

to compute the net present value?

a. $1,300,000.

b. $1,500,000.

c. $1,700,000.

d. $1,900,000.

Topic: Discounted Cash Flow Analysis

Colvern Corporation is considering the acquisition of a new computer-aided machine tool to replace

an existing, outdated model. Relevant information includes the following.

Annual depreciation - new machine 16,000

Annual depreciation - old machine 1,600

Income tax rate 40%

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Section E: Investment Decisions

a. $5,600.

b. $7,440.

c. $17,040.

d. $22,800.

Topic: Discounted Cash Flow Analysis

Skytop Industries is analyzing a capital investment project using discounted cash flow (DCF) analysis.

The new equipment will cost $250,000. Installation and transportation costs aggregating $25,000 will

be capitalized. A five year MACRS depreciation schedule (20%, 32%, 19.2%, 11.52%, 11.52%,

5.76%) with the half-year convention will be employed. Existing equipment, with a book value of

$100,000 and an estimated market value of $80,000, will be sold immediately after installation of the

new equipment. Annual incremental pre-tax cash inflows are estimated at $75,000. Skytop’s effective

income tax rate is 40%. After-tax cash flow for the first year of the project would amount to

a. $45,000.

b. $52,000.

c. $67,000.

d. $75,000.

Topic: Discounted Cash Flow Analysis

Skytop Industries is analyzing a capital investment project using discounted cash flow (DCF) analysis.

The new equipment will cost $250,000. Installation and transportation costs aggregating $25,000 will

be capitalized. Existing equipment will be sold immediately after installation of the new equipment.

The existing equipment has a tax basis of $100,000 and an estimated market value of $80,000. Skytop

estimates that the new equipment’s capacity will generate additional receivables and inventory of

$30,000, while payables will increase by $15,000. Annual incremental pre-tax cash inflows are

estimated at $75,000. Skytop’s effective income tax rate is 40%. Total after-tax cash outflows

occurring in Year 0 would be

a. $177,000.

b. $182,000.

c. $198,000.

d. $202,000.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

Mintz Corporation is considering the acquisition of a new technologically efficient packaging machine

at a cost of $300,000. The equipment requires an immediate, fully recoverable, investment in working

capital of $40,000. Mintz plans to use the machine for five years, is subject to a 40% income tax rate,

and uses a 12% hurdle rate when analyzing capital investments. The company employs the net present

value method (NPV) to analyze projects.

The overall impact of the working capital investment on Mintz’s NPV analysis is

a. $(10,392).

b. $(13,040).

c. $(17,320).

d. $(40,000).

Topic: Discounted Cash Flow Analysis

Regis Company, which is subject to an effective income tax rate of 30%, is evaluating a proposed

capital project. Relevant information for the proposed project is summarized below.

Annual operating cash inflows

for the first three years.

Year 1 185,000

Year 2 175,000

Year 3 152,000

Depreciation will be calculated under the straight-line method using an 8-year estimated service life

and a terminal value of $50,000. In determining the estimated total after-tax cash flow in Year 2 of the

project, Regis should consider the after-tax operating cash

a. inflow only.

b. inflow plus annual depreciation expense.

c. inflow plus annual depreciation tax shield.

d. inflow plus the net impact of the annual depreciation expense and depreciation tax shield.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

For each of the next six years Atlantic Motors anticipates net income of $10,000, straight-line tax

depreciation of $20,000, a 40% tax rate, a discount rate of 10%, and cash sales of $100,000. The

depreciable assets are all being acquired at the beginning of year 1 and will have a salvage value of

zero at the end of six years.

a. $8,000.

b. $27,072.

c. $34,840.

d. $87,100.

Topic: Discounted Cash Flow Analysis

Annual sales are expected to be 50,000 units in the first year, 100,000 units in the second year, and

125,000 units the year thereafter. Selling price will be $80 in the first year and is expected to decrease

by 5% per year. Annual costs are forecasted as follows.

Labor cost per unit $20 in year 1, increasing 5% per year, thereafter

Material cost per unit $30 in year 1, increasing 10% per year, thereafter

The investment of $2 million will be depreciated on a straight-line basis over 4 years for financial

reporting and tax purposes. Webster’s effective tax rate is 40%. When calculating net present value

(NPV), the net cash flow for year 3 would be

a. $558,750.

b. $858,750.

c. $1,058,750.

d. $1,070,000.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

Skytop Industries is analyzing a capital investment project using discounted cash flow (DCF) analysis.

The new equipment will cost $250,000. Installation and transportation costs aggregating $25,000 will

be capitalized. The appropriate five year depreciation schedule (20%, 32%, 19%, 14.5%, 14.5%) will

be employed with no terminal value factored into the computations. Annual incremental pre-tax cash

inflows are estimated at $75,000. Skytop’s effective income tax rate is 40%. Assuming the machine

is sold at the end of Year 5 for $30,000, the after-tax cash flow for Year 5 of the project would amount

to

a. $63,950.

b. $72,950.

c. $78,950.

d. $86,925.

Topic: Discounted Cash Flow Analysis

product. The equipment is expected to last nine years, produce revenue of $700,000 per year, and

have related cash expenses of $450,000 per year. At the end of the 9th year, the equipment is expected

to have a salvage value of $100,000 and cost $50,000 to remove. The IRS categorizes this as 5-year

Modified Accelerated Cost Recovery System (MACRS) property subject to the following depreciation

rates.

Year Rate

1 20.00%

2 32.00%

3 19.20%

4 11.52%

5 11.52%

6 5.76%

Fuller’s effective income tax rate is 40% and Fuller expects, on an overall company basis, to continue

to be profitable and have significant taxable income. If Fuller uses the net present value method to

analyze investments, what is the expected net tax impact on cash flow in Year 2 before discounting?

b. $0 impact.

c. Negative $100,000 impact.

d. Negative $128,000 impact.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

Allstar Company invests in a project with expected cash inflows of $9,000 per year for four years. All

cash flows occur at year-end. The required return on investment is 9%. If the project generates a net

present value (NPV) of $3,000, what is the amount of the initial investment in the project?

a. $11,253.

b. $13,236.

c. $26,160.

d. $29,160.

Topic: Discounted Cash Flow Analysis

AGC Company is considering an equipment upgrade. AGC uses discounted cash flow (DCF) analysis

in evaluating capital investments and has an effective tax rate of 40%. Selected data developed by

AGC is as follows.

Existing New

Equipment Equipment

Original cost $50,000 $95,000

Accumulated depreciation 45,000 -

Current market value 3,000 95,000

Accounts receivable 6,000 8,000

Accounts payable 2,100 2,500

Based on this information, what is the initial investment for a DCF analysis of this proposed upgrade?

a. $92,400.

b. $92,800.

c. $95,800.

d. $96,200.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

Topeka Products uses the net present value (NPV) method to evaluate capital projects. Topeka plans

to acquire a depreciable asset on January 1 of next year for $2.4 million. The new asset has an

estimated service life of four years, a zero terminal disposal value, and will be depreciated on a

straight-line basis. The new asset will replace an existing asset that is expected to be sold for

$350,000. The tax basis of the existing asset is $330,000. Topeka is subject to an effective income tax

rate of 40% and assumes that any gains or losses affect the taxes paid at the end of the year in which

the gains or losses occur. Topeka uses a 10% discount rate for NPV analyses.

The amount related to the new asset’s depreciation that would be included in an NPV analysis is

a. $760,800.

b. $1,141,200.

c. $1,639,200.

d. $1,902,000.

Topic: Discounted Cash Flow Analysis

Calvin Inc. is considering the purchase of a new state-of-art machine to replace its hand-operated

machine. Calvin's effective tax rate is 40%, and its cost of capital is 12%. Data regarding the existing

and new machines are presented below.

Existing New

Machine Machine

Original cost $50,000 $90,000

Installation cost 0 4,000

Freight and insurance 0 6,000

Expected end salvage value 0 0

Depreciation method straight-line straight-line

Expected useful life 10 years 5 years

The existing machine has been in service for seven years and could be sold currently for $25,000. If

the new machine is purchased Calvin expects to realize a $30,000 before-tax annual reduction in labor

costs.

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Section E: Investment Decisions

If the new machine is purchased, what is the net amount of the initial cash outflow at Time 0 for net

present value calculation purposes?

a. $65,000.

b. $75,000.

c. $79,000.

d. $100,000.

Topic: Discounted Cash Flow Analysis

Olson Industries needs to add a small plant to accommodate a special contract to supply building

materials over a five year period. The required initial cash outlays at Time 0 are as follows.

Land $ 500,000

New building 2,000,000

Equipment 3,000,000

Olson uses straight-line depreciation for tax purposes and will depreciate the building over 10 years

and the equipment over 5 years. Olson’s effective tax rate is 40%.

Revenues from the special contract are estimated at $1.2 million annually and cash expenses are

estimated at $300,000 annually. At the end of the fifth year, the assumed sales values of the land and

building are $800,000 and $500,000, respectively. It is further assumed the equipment will be

removed at a cost of $50,000 and sold for $300,000.

As Olson utilizes the net present value (NPV) method to analyze investments, the net cash flow for

period 5 would be

a. $1,710,000.

b. $2,070,000.

c. $2,230,000.

d. $2,390,000.

Topic: Discounted Cash Flow Analysis

Calvin Inc. is considering the purchase of a new state-of-art machine to replace its hand-operated

machine. Calvin's effective tax rate is 40%, and its cost of capital is 12%. Data regarding the existing

and new machines are presented below.

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Section E: Investment Decisions

Existing New

Machine Machine

Original cost $50,000 $90,000

Installation costs 0 4,000

Freight and insurance 0 6,000

Expected end salvage value 0 0

Depreciation method straight-line straight-line

Expected useful life 10 years 5 years

The existing machine has been in service for five years and could be sold currently for $25,000.

Calvin expects to realize annual before-tax reductions in labor costs of $30,000 if the new machine is

purchased and placed in service.

If the new machine is purchased, the incremental cash flows for the first year would amount to

a. $18,000.

b. $24,000.

c. $30,000.

d. $45,000.

Topic: Discounted Cash Flow Analysis

Kell Inc. is analyzing an investment for a new product expected to have annual sales of 100,000 units

for the next 5 years and then be discontinued. New equipment will be purchased for $1,200,000 and

cost $300,000 to install. The equipment will be depreciated on a straight-line basis over 5 years for

financial reporting purposes and 3 years for tax purposes. At the end of the fifth year, it will cost

$100,000 to remove the equipment, which can be sold for $300,000. Additional working capital of

$400,000 will be required immediately and needed for the life of the product. The product will sell for

$80, with direct labor and material costs of $65 per unit. Annual indirect costs will increase by

$500,000. Kell’s effective tax rate is 40%.

In a capital budgeting analysis, what is the expected cash flow at time = 3 (3rd year of operation) that

Kell should use to compute the net present value?

a. $300,000.

b. $720,000.

c. $760,000.

d. $800,000.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

The owner of Woofie’s Video Rental cannot decide how to project the real costs of opening a rental

store in a new shopping mall. The owner knows the capital investment required but is not sure of the

returns from a store in a new mall. Historically, the video rental industry has had an inflation rate

equal to the economic norm. The owner requires a real internal rate of return of 10%. Inflation is

expected to be 3% during the next few years. The industry expects a new store to show a growth rate,

without inflation, of 8%. First year revenues at the new store are expected to be $400,000.

The revenues for the second year, using both the real rate approach and the nominal rate approach,

respectively, would be

b. $432,000 real and $452,000 nominal.

c. $440,000 real and $452,000 nominal.

d. $440,000 real and $453,200 nominal.

Topic: Discounted Cash Flow Analysis

Nolan Hospital has decided to acquire diagnostic equipment from Weber Medical Products based on

Weber’s reputation for quality. Weber has offered Nolan four payment options, as shown in the

following table. All payments would be due and paid at the beginning of each year.

Options

Year (dollars in millions)

I II III IV

1 $5 $18

2 5 $10

3 5 10

4 5 $22

Nolan’s cost of funds is 8%. Which payment option should Nolan choose?

a. I.

b. II.

c. III.

d. IV.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

(percent) Project A Project B

0 $2,220 $1,240

10 681 507

12 495 411

14 335 327

16 197 252

18 77 186

20 (26) 128

22 (115) 76

24 (193) 30

26 (260) (11)

28 (318) (47)

The approximate internal rates of return for Projects A and B, respectively, are

a. 0% and 0%.

b. 19.0% and 21.5%.

c. 19.5% and 25.5%.

d. 20.5% and 26.5%.

Topic: Discounted Cash Flow Analysis

Bell Delivery Co. is financing a new truck with a loan of $30,000, to be repaid in five annual

installments of $7,900 at the end of each year. What is the approximate annual interest rate Bell is

paying?

a. 4%.

b. 5%.

c. 10%.

d. 16%.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

Kunkle Products is analyzing whether or not to invest in equipment to manufacture a new product.

The equipment will cost $1 million, is expected to last 10 years, and will be depreciated on a straight-

line basis for both financial reporting and tax purposes. Kunkle’s effective tax rate is 40%, and its

hurdle rate is 14%. Other information concerning the project is as follows.

Selling price = $100 per unit

Variable cost = $70 per unit

A 10% reduction in variable costs would result in the net present value increasing by approximately

a. $156.000.

b. $219,000.

c. $365,000.

d. $367,000.

Topic: Discounted Cash Flow Analysis

Two mutually exclusive capital expenditure projects have the following characteristics.

Project A Project B

Investment $100,000 $150,000

Net cash inflow - Year 1 40,000 80,000

Year 2 50,000 70,000

Year 3 60,000 60,000

All cash flows are received at the end of the year. Based on this information, which one of the

following statements is not correct?

b. The net present value of Project B at a cost of capital of 12% is $19,950.

c. The profitability index of Project B is greater than the profitability index of Project A.

d. The payback years for Project A is greater than the payback years for Project B.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

Wilcox Corporation won a settlement in a law suit and was offered four different payment alternatives

by the defendant’s insurance company. A review of interest rates indicates that 8% is appropriate for

analyzing this situation. Ignoring any tax considerations, which one of the following four alternatives

should the controller recommend to Wilcox management?

a. $135,000 now.

b. $40,000 per year at the end of each of the next four years.

c. $5,000 now and $20,000 per year at the end of each of the next ten years.

d. $5,000 now and $5,000 per year at the end of each of the next nine years, plus a lump-sum

payment of $200,000 at the end of the tenth year.

Topic: Discounted Cash Flow Analysis

Smithco is considering the acquisition of scanning equipment to mechanize its procurement process.

The equipment will require extensive testing and debugging, as well as user training prior to its

operational use. Projected after-tax cash flows are shown below.

Year Inflow/(Outflow)

0 $(550,000)

1 $(500,000)

2 $450,000

3 $350,000

4 $350,000

5 $350,000

Management anticipates the equipment will be sold at the beginning of year 6 for $50,000 when its

book value is zero. Smithco’s internal hurdle and effective tax rates are 14% and 40%, respectively.

The project’s net present value would be

a. $(1,780).

b. $(6,970).

c. $(17,350).

d. $8,600.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

Verla Industries is trying to decide which one of the following two options to pursue. Either option

will take effect on January 1st of the next year.

The cost of the machine is $1,000,000 and will have a useful life of five years. Net pre-tax cash flows

arising from savings in labor costs will amount to $100,000 per year for five years. Depreciation

expense will be calculated using the straight-line method for both financial and tax reporting purposes.

As an incentive to purchase, Verla will receive a trade-in allowance of $50,000 on their current fully

depreciated finishing machine.

Verla can outsource the work to LM Inc. at a cost of $200,000 per year for five years. If they

outsource, Verla will scrap their current fully depreciated finishing machine.

Verla’s effective income tax rate is 40%. The weighted-average cost of capital is 10%.

is

b. $404,920 net cash outflow.

c. $454,920 net cash outflow.

d. $758,200 net cash outflow.

Topic: Discounted Cash Flow Analysis

Verla Industries is trying to decide which one of the following two options to pursue. Either option

will take effect on January 1st of the next year.

The cost of the machine is $1,000,000 and will have a useful life of five years. Net pre-tax cash flows

arising from savings in labor costs will amount to $100,000 per year for five years. Depreciation

expense will be calculated using the straight-line method for both financial and tax reporting purposes.

As an incentive to purchase, Verla will receive a trade-in allowance of $50,000 on their current fully

depreciated finishing machine.

Verla can outsource the work to LM Inc. at a cost of $200,000 per year for five years. If they

outsource, Verla will scrap their current fully depreciated finishing machine.

Verla’s effective income tax rate is 40%. The weighted-average cost of capital is 10%.

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Section E: Investment Decisions

b. $267,620 net cash outflow.

c. $369,260 net cash outflow.

d. $434,424 net cash outflow.

Topic: Discounted Cash Flow Analysis

Jenson Copying Company is planning to buy a coping machine costing $25,310. The net present

values (NPV) of this investment, at various discount rates, are as follows.

4% $2,440

6% $1,420

8% $ 460

10% ($ 440)

a. 6%.

b. 8%.

c. 9%.

d. 10%.

Topic: Discounted Cash Flow Analysis

Fred Kratz just completed a capital investment analysis for the acquisition of new material handling

equipment. The equipment is expected to cost $1,000,000 and be used for eight years. Kratz reviewed

the net present value (NPV) analysis with Bill Dolan, Vice President of Finance. The analysis shows

that the tax shield for this investment has a positive NPV of $200,000, using the firm’s hurdle rate of

20%. Dolan noticed that 8 year straight-line depreciation was used for tax purposes but, since this

equipment qualifies for 3-year MACRS treatment, the tax shield analysis should be revised. The

company has an effective tax rate of 40%. The MACRS rates for 3-year property are as follows.

Year Rate

1 33.33%

2 44.45%

3 14.81%

4 7.41%

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Section E: Investment Decisions

Accordingly, the revised NPV for the tax shield (rounded to the nearest thousand) should be

a. $109,000.

b. $192,000.

c. $283,000.

d. $425,000.

Topic: Discounted Cash Flow Analysis

Foster Manufacturing is analyzing a capital investment project that is forecasted to produce the

following cash flows and net income.

After-Tax Net

Years Cash Flows Income

0 $(20,000) $ 0

1 6,000 2,000

2 6,000 2,000

3 8,000 2,000

4 8,000 2,000

If Foster’s cost of capital is 12%, the net present value for this project is

a. $(1,600).

b. $924.

c. $6,074.

d. $6,998.

Topic: Discounted Cash Flow Analysis

Lunar Inc. is considering the purchase of a machine for $500,000 which will last 5 years. A financial

analysis is being developed using the following information.

Variable cost per unit 65 65 65 65 65

Fixed costs 300,000 300,000 300,000 300,000 300,000

Pre-tax cash flow 50,000 50,000 400,000 400,000 400,000

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Section E: Investment Decisions

The machine will be depreciated over 5 years on a straight-line basis for tax purposes and Lunar is

subject to a 40% effective income tax rate. Assuming Lunar will have significant taxable income from

other lines of business, and using a 20% discount rate, the net present value of the project would be

a. $(282,470).

b. $(103,070).

c. $(14,010).

d. $16,530.

Topic: Discounted Cash Flow Analysis

Foster Manufacturing is analyzing a capital investment project that is forecasted to produce the

following cash flows and net income.

Year Cash-Flows Income

0 $(20,000) $ 0

1 6,000 2,000

2 6,000 2,000

3 8,000 2,000

4 8,000 2,000

If Foster’s cost of capital is 12%, the internal rate of return (rounded to the nearest whole percentage)

is

a. 5%.

b. 12%.

c. 14%.

d. 40%.

Topic: Risk Analysis in Capital Investments

Ironside Products is considering two independent projects, each requiring a cash outlay of $500,000

and having an expected life of 10 years. The forecasted annual net cash inflows for each project and

the probability distributions for these cash inflows are as follows.

Project R Project S

Probabilities Cash Inflows Probabilities Cash Inflows

0.10 $ 75,000 0.25 $ 70,000

0.80 95,000 0.50 110,000

0.10 115,000 0.25 150,000

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Section E: Investment Decisions

Ironside has decided that the project with the greatest relative risk should meet a hurdle rate of 16%

and the project with less risk should meet a hurdle rate of 12%. Given these parameters, which of the

following actions should be recommended for Ironside to undertake?

b. Accept Project R and reject Project S.

c. Reject Project R and accept Project S.

d. Accept both projects.

Topic: Discounted Cash Flow Analysis

Logan Enterprises is at a critical decision point and must decide whether to go out of business or

continue to operate for five more years. Logan has a labor contract with five years remaining which

calls for $1.5 million in severance pay if Logan’s plant shuts down. The firm also has a contract to

supply 150,000 units per year, at a price of $100 each, to Dill Inc. for the next five years. Dill is

Logan’s only remaining customer. Logan must pay Dill $500,000 immediately if it defaults on the

contract. The plant has a net book value of $600,000, and appraisers estimate the facility would sell

for $750,000 today but would have no market value if operated for another five years. Logan’s fixed

costs are $4 million per year, and variable costs are $75 per unit. Logan’s appropriate discount rate is

12%. Ignoring taxes, the optimal decision is to

a. shut down because the annual cash flow is negative $250,000 per year.

b. keep operating to avoid the severance pay of $1,500,000.

c. shut down since the breakeven point is 160,000 units while annual sales are 150,000 units.

d. keep operating since the incremental net present value is approximately $350,000.

Topic: Ranking Investment Projects

Hobart Corporation evaluates capital projects using a variety of performance screens. These include:

a hurdle rate of 16%, payback period of less than 3 years, and an accounting rate of return greater than

20%. Management is completing review of a project on the basis of the following projections.

• Annual cash flows $65,000

• Straight-line depreciation 8 years

• Terminal value $20,000

The projected net present value is a negative $2,000. Which one of the following alternatives reflects

the appropriate conclusions for the indicated evaluative measures?

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Section E: Investment Decisions

Net Present

Value Payback

a. Accept Reject.

b. Reject Accept.

c. Accept Accept.

d. Reject Reject.

Topic: Discounted Cash Flow Analysis

Staten Corporation is considering two mutually exclusive projects. Both require an initial outlay of

$150,000 and will operate for five years. The cash flows associated with these projects are as follows.

1 $ 47,000 $ 0

2 47,000 0

3 47,000 0

4 47,000 0

5 47,000 280,000

Total $235,000 $280,000

Staten’s required rate of return is 10 percent. Using the net present value method, which one of the

following actions would you recommend to Staten?

b. Accept Project Y, and reject Project X.

c. Accept Projects X and Y.

d. Reject Projects X and Y.

Topic: Discounted Cash Flow Analysis

Jones & Company is considering the acquisition of scanning equipment to mechanize its procurement

process. The equipment will require extensive testing and debugging as well as user training prior to

its operational use. Projected after-tax cash flows are as follows.

Time Period After-Tax Cash

Year Inflow/(Outflow)

0 $(600,000)

1 (500,000)

2 450,000

3 450,000

4 350,000

5 250,000

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Section E: Investment Decisions

Management anticipates the equipment will be sold at the beginning of Year 6 for $50,000 and its

book value will be zero. Jones’ internal hurdle and effective income tax rates are 14% and 40%,

respectively. Based on this information, a negative net present value was computed for the project.

Accordingly, it can be concluded that

a. the project has an internal rate of return (IRR) less than 14% since IRR is the interest rate at

which net present value is equal to zero.

b. Jones should examine the determinants of its hurdle rate further before analyzing any other

potential projects.

c. Jones should calculate the project payback to determine if it is consistent with the net present

value calculation.

d. the project has an IRR greater than 14% since IRR is the interest rate at which net present

value is equal to zero.

Topic: Discounted Cash Flow Analysis

Stennet Company is considering two mutually exclusive projects. The company’s cost of capital is

10%. The net present value (NPV) profiles of the two projects are as follows.

(percent) Project A Project B

0 $2,220 $1,240

10 681 507

12 495 411

14 335 327

16 197 252

18 77 186

20 (26) 128

22 (115) 76

24 (193) 30

26 (260) (11)

28 (318) (47)

The company president is of the view that Project B should be accepted because it has the higher

internal rate of return (IRR). The president requested John Mack, the CFO, to make a

recommendation. Which one of the following options should Mack recommend to the president?

b. Accept Project A because it has an IRR higher than that of Project B.

c. Accept both Projects A and B as the IRR for each project is greater than cost of capital.

d. Accept Project A because at a 10% discount rate it has an NPV that is greater than that of

Project B.

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Section E: Investment Decisions

Topic: Payback and Discounted Payback

Hobart Corporation evaluates capital projects using a variety of performance screens; including a

hurdle rate of 16%, payback period of 3 years or less, and an accounting rate of return of 20% or more.

Management is completing review of a project on the basis of the following projections.

• Annual cash flows $74,000

• Straight-line depreciation 5 years

• Terminal value $20,000

The projected internal rate of return is 20%. Which one of the following alternatives reflects the

appropriate conclusions for the indicated evaluative measures?

Internal Rate

of Return Payback

a. Accept Reject.

b. Reject Reject.

c. Accept Accept.

d. Reject Accept.

Topic: Payback and Discounted Payback

Quint Company uses the payback method as part of its analysis of capital investments. One of its

projects requires a $140,000 investment and has the following projected before-tax cash flows.

Year 1 $60,000

Year 2 60,000

Year 3 60,000

Year 4 80,000

Year 5 80,000

Quint has an effective 40% tax rate. Based on these data, the after-tax payback period is

a. 1.5.

b. 2.3.

c. 3.4.

d. 3.7.

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Section E: Investment Decisions

Topic: Payback and Discounted Payback

Foster Manufacturing is analyzing a capital investment project that is forecasted to produce the

following cash flows and net income.

After-Tax Net

Year Cash flow Income

0 ($20,000) $ 0

1 6,000 2,000

2 6,000 2,000

3 8,000 2,000

4 8,000 2,000

a. 2.5 years.

b. 2.6 years.

c. 3.0 years.

d. 3.3 years.

Topic: Payback and Discounted Payback

Miller Inc. uses straight-line depreciation for both tax and financial reporting purposes. The following

data relate to Machine No. 108, which cost $400,000 and is being written-off over a five-year life.

Savings in Cash

Year Operating Income Operating Costs

1 $150,000 $230,000

2 200,000 280,000

3 225,000 305,000

4 225,000 305,000

5 175,000 255,000

All of these amounts are on a before-tax basis. Miller is subject to a 40% income tax rate. The

company strives for a 12% rate of return. The traditional payback period for Machine No. 108 would

be

a. 2.14 years.

b. 2.44 years.

c. 2.58 years.

d. 3.41 years.

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Section E: Investment Decisions

Topic: Payback and Discounted Payback

Smithco is considering the acquisition of scanning equipment to mechanize its procurement process.

The equipment will require extensive testing and debugging, as well as user training prior to its

operational use. Projected after-tax cash flows are shown below.

Year Inflow/(Outflow)

0 $(550,000)

1 $(500,000)

2 $450,000

3 $350,000

4 $250,000

5 $150,000

Management anticipates the equipment will be sold at the beginning of year 6 for $50,000 when its

book value is zero. Smithco’s internal hurdle and effective tax rates are 14% and 40%, respectively.

The project’s payback period will be

a. 2.3 years.

b. 3.0 years.

c. 3.5 years.

d. 4.0 years.

Topic: Ranking Investment Projects

Diane Harper, Vice President of Finance for BGN Industries, is reviewing material prepared by her

staff prior to the board of directors meeting at which she must recommend one of four mutually

exclusive options for a new product line. The summary information below indicates the initial

investment required, the present value of cash inflows (excluding the initial investment) at BGN’s

hurdle rate of 16%, and the internal rate of return (IRR) for each of the four options.

Present Value of

Option Investment Cash Inflows at 16% IRR

X $3,950,000 $3,800,000 15.5%

Y 3,000,000 3,750,000 19.0%

Z 2,000,000 2,825,000 17.5%

W 800,000 1,100,000 18.0%

If there are no capital rationing constraints, which option should Harper recommend?

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Section E: Investment Decisions

a. Option X.

b. Option Y.

c. Option Z.

d. Option W.

Topic: Ranking Investment Projects

Wearwell Company is considering three investment projects. Wearwell’s president asked the

controller to prepare a report and recommend an appropriate investment decision. The results of the

controller’s calculations for the three projects are as follows.

A $20,680 12%

B 30,300 10%

C 15,000 13%

The company expects a minimum net present value (NPV) of $20,000 from accepted projects. The

projects are mutually exclusive and Wearwell’s cost of capital is 8%. Which one of the following

options should the controller recommend to the president?

b. Project B because it has the highest net present value (NPV).

c. Projects A, B, and C because each of the projects have an IRR greater than the cost of capital.

d. Projects A and B because they exceed the minimum expected NPV.

Topic: Ranking Investment Projects

Zinx Corporation has a maximum of $5,000,000 available for investments. The company has

identified the following investment options.

Discounted

Project Investment Cash Flow

I $2,800,000 $3,360,000

II 1,500,000 1,720,000

III 2,300,000 2,617,000

IV 1,200,000 1,368,000

V 800,000 1,000,000

b. II, III, and V.

c. I and II.

d. I, IV, and V.

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Section E: Investment Decisions

Topic: Ranking Investment Projects

Carbide Inc. has the following investment opportunities. Required investment outlays and the

profitability index for each of these investments are as follows.

I $300,000 0.5

II 450,000 1.4

III 650,000 1.8

IV 750,000 1.6

Carbide’s budget ceiling for initial outlays during the present period is $1,500,000. The proposed

projects are independent of each other. Which project or projects would you recommend that Carbide

accept?

a. III.

b. III and IV.

c. I, II, and IV.

d. I, III, and IV.

Topic: Ranking Investment Projects

Dobson Corp. is analyzing a capital investment requiring a cash outflow at Time 0 of $2.5 million and

net cash inflows of $800,000 per year for 5 years. The net present value (NPV) was calculated to be

$384,000 at a 12% discount rate. Since several managers felt this was a risky project, three separate

scenarios were analyzed, as follows.

• Scenario S - The discount rate was changed to 18%.

• Scenario T - The cash inflow in year 5 was reduced to zero.

Rank the three individual scenarios in the order of the effect on NPV, from least effect to greatest

effect.

a. R, S, T.

b. R, T, S.

c. S, T, R.

d. T, S, R.

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Section E: Investment Decisions

Topic: Risk Analysis in Capital Investments

Long Inc. is analyzing a $1 million investment in new equipment to produce a product with a $5 per

unit margin. The equipment will last 5 years, be depreciated on a straight-line basis for tax purposes,

and have no value at the end of its life. A study of unit sales produced the following data.

Annual

Unit Sales Probability

80,000 .10

85,000 .20

90,000 .30

95,000 .20

100,000 .10

110,000 .10

If Long utilizes a 12% hurdle rate and is subject to a 40% effective income tax rate, the expected net

present value of the project would be

a. $261,750.

b. $283,380.

c. $297,800.

d. $427,580.

Topic: Risk Analysis in Capital Investments

Parker Industries is analyzing a $200,000 equipment investment to produce a new product for the next

5 years. A study of expected annual after-tax cash flows from the project produced the following data.

Annual

After-Tax

Cash Flow Probability

$45,000 .10

50,000 .20

55,000 .30

60,000 .20

65,000 .10

70,000 .10

If Parker utilizes a 14% hurdle rate, the probability of achieving a positive net present value is

a. 20%.

b. 30%.

c. 40%.

d. 60%.

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CMA Part 3 –Strategic Management

Part 3 Question

Answers & Explanations

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Question Answers & Explanations CMA Part 3 –Strategic Management

Section C: Corporate Finance

Topic: Risk and Return

Feedback: The correct answer is: greater than $40.00, if the dividend is changed to $0.45 per new

share.

The price of a common stock is calculated by taking the present value of its projected dividend stream,

computed using the expected return on the stock. If during a two-for-one stock split, the dividend is

split two-for-one to $0.50 per share, then the stock price will become half of its current value, or $40.

If the dividend is cut by less than 50%, to $0.55 in this case, then the stock price after the split will be

greater than $40 per share.

Topic: Risk and Return

The dividend paid would be $0.60 per share, multiplied by the number of shares outstanding. The

number of outstanding shares is 20,000, and is calculated by taking the number of issued shares and

subtracting the number of share that were repurchased and held in treasury.

Number of shares = (25,000) – (5,000)

Number of shares = 20,000

Topic: Risk and Return

The price of the common stock using the Constant Dividend Growth Model (Gordon’s Model) is

calculated as follows:

Price of common stock = (next period’s dividend)(cost of common equity – constant growth rate)

The cost of common equity using the Capital Asset Pricing Model is calculated as follows:

Cost of common equity = (risk-free rate) + (return on market – risk free rate)(beta value)

Cost of common equity = (7%) + (15%-7%)(1.25) = 17%

Next period’s dividend = (35%)($4) = $1.40

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Section C: Corporate Finance

Therefore, the price of the common stock using Gordon’s model is:

Topic: Financial Instruments

A firm using the residual dividend policy would first reinvest earnings in the firm. Any residual

amount remaining would be paid out in dividends. Given an 11% cost of capital, Mason would invest

in the three projects that have IRR’s greater than 11%, which would include a total investment of

$1,120,000 ($200,000 for Project A, $350,000 for Project B, and $570,000 for Project C).

Given a 60% equity financing structure, 60% of the investment would be from the $1,000,000 in

earnings, ending up with $672,000.

(0.6)($1,120,000) = $672,000

The remaining amount of $328,000 ($1,000,000 – $672,000) would be available for dividends.

Topic: Financial Instruments

The cost of preferred stock capital is calculated as follows:

Cost of preferred stock capital = (preferred stock dividend per share) / (net price of the preferred stock)

Dividend per share = (dividend rate)(par value of stock)

Dividend per share = (0.08)($100) = $8 per share

Therefore, the cost of preferred stock capital = $8 / $92 = 0.09195, which rounds to 9.20%.

Topic: Financial Instruments

The earnings per share (EPS) for Clark is calculated as follows:

EPS = (net income – preferred stock dividends) / (weighted average number of common stock shares

outstanding)

EPS = ($3,750,000 – $0) / (3,000,000 shares) = $1.25 per share.

The estimated value per share of Clark stock can then be calculated as follows:

Estimated value per share = 12($1.25) = $15.00 per share.

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Section C: Corporate Finance

Topic: Financial Instruments

Book value per share of common stock is calculated by taking the common stock equity and dividing

it by the number of shares of common stock outstanding.

Book value per share, common stock = (common stock equity) / (number of shares of common stock

outstanding)

The number of shares outstanding is 3,000,000, which is derived by taking the $3,000,000 in par value

common equity and dividing it by the $1 par value per share.

Therefore, book value per share of common stock can be calculated as follows:

Book value per share, common stock = ($3,000,000 + $24,000,000 + $6,000,000) / (3,000,000 shares)

Book value per share, common stock = ($33,000,000) / (3,000,000 shares)

Book value per share, common stock = $11 per share

Estimated value per share = $11(1.5) = $16.50 per share.

Topic: Cost of Capital

The cost of capital for retained earnings, using the Constant Dividend Growth Model (Gordon’s

Model) is calculated as follows:

Cost of capital, retained earnings = (next dividend) / (net price of common stock) + (constant growth

rate)

In this case, the next dividend is calculated by taking the current dividend of $3.00 per share and

multiplying it by one plus the constant growth rate, as follows:

Value of next dividend = $3(1 + 0.09) = $3.27.

Therefore, the cost of capital for retained earnings can be calculated as follows:

Cost of capital, retained earnings = ($3.27 / $36) + (0.09) = 0.0908 + 0.09 = 0.1808, or 18.08%.

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Section C: Corporate Finance

Topic: Cost of Capital

Leverage involves the use of non-common stock equity to enhance the return on common stock equity.

The most highly leveraged firm would be the one with the lowest percent of common equity in its

capital structure. Sterling has the lowest percent of common equity in its capital structure.

Topic: Cost of Capital

Angela’s weighted average cost of capital is given at 10.41%. The formula to calculated the weighted

average cost of capital is as follows:

Weighted average cost of capital (WACC) = (weighted cost of debt, or wi)(after-tax cost of debt) + (1

– wi)(cost of common equity).

Where: wi = the company’s weighting or portion of debt

After-tax cost of debt = (1 – tax rate)(% cost of debt)

After-tax cost of debt = (1 – 0.4)(0.08) = 0.6(0.08) = 0.048, or 4.8%.

This amount can then be substituted into the WACC formula as follows:

10.41% = 4.8%(wi) + (1 – wi)(15%)

10.41%= 4.8%(wi) +15% – 15%(wi)

-4.59% = -10.2%(wi)

wi = 4.59% / 10.2% = 45%

Topic: Cost of Capital

The cost of capital for retained earnings using the Constant Dividend Growth Model (Gordon’s

Model) is calculated as follows:

Cost of capital, retained earnings = (next dividend) / (net price of the common stock) + (constant

growth rate)

The next dividend is calculated by taking the current dividend per share and multiplying it by one plus

the constant growth rate.

Next dividend = (current dividend)(1 + constant growth rate)

Next dividend = ($2.00 per share)(1 + 10%) = $2(1.1) = $2.20 per share.

Cost of capital, retained earnings = ($2.20 / $38) + (0.1) = 0.058 + 0.1 = 0.158, or 15.8%.

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Section C: Corporate Finance

Topic: Cost of Capital

The weighted average cost capital (WACC) is calculated as follows:

WACC = (weight of long-term debt)(after-tax cost of long-term debt) + (weight of common

stock)(cost of common stock) + (weight of retained earnings)(cost of retained earnings)

The total of long-term debt, common stock, and retained earnings = $10,000,000 + $10,000,000 +

$5,000,000 = $25,000,000. From this information, the weight of long-term debt, common stock, and

retained earnings can be determined as follows:

Weight for common stock = ($10,000,000) / ($25,000,000) = 0.4, and

Weight for retained earnings = ($5,000,000 / $25,000,000) = 0.2.

Topic: Cost of Capital

Kielly had net income available to common shareholders of $184 million last year, of which 75% was

paid out in dividends. That would mean that the remaining portion of 25% would remain as retained

earnings available for investment

Retained earnings, available for investment = (0.25)($184,000,000) = $46,000,000.

The $46,000,000 in retained earnings is equal to 46% of the $100,000,000 in investment funds needed.

Therefore, no issue of common stock is needed.

WACC = (weight of long-term debt)(after-tax cost of long-term debt) + (weight of common

stock)(cost of common stock) + (weight of retained earnings)(cost of retained earnings)

After-tax cost of debt = (1 – tax rate)(before-tax cost of debt)

After-tax cost of debt = (1 – 0.4)(0.11) = 0.066, or 6.6%.

Therefore, the weighted average cost of capital (WACC) can be calculated as follows:

WACC = (0.3)(0.066) + (0.24)(0.12) + (0.46(0.16)

WACC = .0198 + 0.0288 + 0.0736 = 0.1222, or 12.22%

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Section C: Corporate Finance

Topic: Cost of Capital

The weighted average cost capital (WACC) is calculated as follows:

WACC = (weight of long-term debt)(after-tax cost of long-term debt) + (weight of common

stock)(cost of common stock) + (weight of retained earnings)(cost of retained earnings)

After-tax cost of debt = (1 – tax rate)(before-tax cost of debt)

After-tax cost of debt = (1 – 0.4)(0.08) = 0.048, or 4.8%

Cost of preferred stock = (dividend on preferred stock, per share) / (price of preferred stock)

Dividend per share on preferred stock = (0.12)(10,000,000 / 100,000) = $12

The total of long-term debt, preferred stock, and common stock = $30,000,000 + $10,000,000 +

$60,000,000 = $100,000,000.

The weights of each of these components can be calculated as follows:

Weight of long-term debt = $30,000,000 / $100,000,000 = 0.3

Weight of preferred stock = $10,000,000 / $100,000,000 = 0.1

Weight of common stock = $60,000,000 / $100,000,000 = 0.6

The weighted average cost of capital (WACC) can now be calculated as follows:

WACC = (0.3)(0.048) + (0.1)(0.096) + (0.6)(0.17) = 0.0144 + 0.96 + 0.102 = 0.126, or 12.6%.

Topic: Cost of Capital

The weighted average cost capital (WACC) is calculated as follows:

WACC = (weight of long-term debt)(after-tax cost of long-term debt) + (weight of preferred

stock)(cost of preferred stock) + (weight of common equity)(cost of common equity)

After-tax cost of debt = (1 – tax rate)(before-tax cost of debt)

After-tax cost of debt = (1-0.4)(0.08) = (0.6)(0.08) = 0.048, or 4.8%.

WACC = 0.0144 + 0.0275 + 0.0675 = 0.1094, or 10.94%

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Section C: Corporate Finance

Topic: Managing Current Assets

Net working capital = current assets – current liabilities

Current assets = $10,000 + $60,000 + $25,000 + $5,000 = $100,000

Current liabilities = ($40,000) + ($10,000) + ($5,000) = $55,000

Topic: Managing Current Assets

The return on marketable securities is part of the interest rate, which is in the denominator of the

formula. Therefore, an increase in the return will decrease the optimal cash balance.

Topic: Financing Current Assets

Feedback: The correct answer is: Lock box, bank float, and electronic transfer only.

Rolling Stone Corporation should select the option with the greatest net benefit, which is calculated by

taking benefits, less associated costs.

Option d. has a net benefit of $4,390, which is made up of net benefits of $990, $2,000, and $1,400 for

the lock box, bank float, and electronic transfer options, respectively. This option has the highest net

benefit of all of the options listed.

The net benefit of the lock box is calculated by taking the $5,240 in interest savings less the cost of

$4,250 ($25 per bank times 170 banks), which comes to $990.

The net benefit of the bank float is $22,000 in interest on the float, less the bank charge of $20,000,

which comes to $2,000. The bank charge is calculated by multiplying $1,000,000 by 2%.

The net benefit of the electronic transfer option is calculated by taking the $14,000 in interest earnings

less a monthly cost of $12,600, to arrive at $1,400. The monthly interest earnings of $12,600 is

calculated by multiplying 700 items by $18.

The net benefit of the drafts is -$1,500, which is calculated by taking the $6,500 in interest savings less

$8,000 (4,000 multiplied by $2) in draft charges.

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Section C: Corporate Finance

The net benefit of option b. = $3,400 ($2,000 + $1,400).

The net benefit of option c. = $890 ($990– $1,500 + $1,400).

Topic: Financing Current Assets

The minimum transfer amount occurs when the net benefit of the wire transfers is equal to the cost of

the DTC.

The net benefit of the transfers is equal to the interest for 2 days saved, less the annual wire transfer

costs.

If x equals the minimum transfer amount, the following equation can be set up:

0.18x = $10.5(360)

x = $21,000

Topic: Financing Current Assets

The projected amount of overdue receivables can be calculated as follows:

Projected amount of overdue receivables = (45 days / 360 days)(20% of sales)

Projected amount of overdue receivables = (45/360)(0.2)($2,000,000) = $50,000

Topic: Financing Current Assets

The amount of interest Burke will pay in the second quarter is $52,500, which is made up of the 9%

interest on the borrowed amount, plus the 0.25% commitment fee on the unused portion.

Given a net inflow of $2,000,000 in April and a net outflow of $7,000,000 in May, Burke will have to

borrow $3,000,000 on May 31 and pay interest for the quarter of $22,500 in June. The interest amount

is calculated as follows: [$3,000,000(0.09)(1/12)] = $22,500.

The commitment fee on the unused portion for the quarter is $30,000 and is calculated as follows:

Commitment fee for April = ($5,000,000)(0.0025) = $12,500

Commitment fee for May = ($5,000,000)(0.0025) = $12,500

Commitment fee for June = ($5,000,000 - $3,000,000)(0.0025) = $5,000

Commitment fee for the quarter = ($12,500 + $12,500 + $5,000) = $30,000

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Section C: Corporate Finance

Topic: Financing Current Assets

The gross margin on the incremental sales of $80,000 will be $32,000.

Gross margin = (sales)(gross margin %)

Gross margin = ($80,000)(0.4)

Gross margin = $32,000

The estimated bad debt loss rate is given at 6% of the incremental sales amount. So, projected bad

debts would be $4,800, which is calculated by multiplying the incremental sales amount of $80,000 by

the bad debt rate of 6%.

To calculate the return on sales before taxes for the new sales amount, use the following equation:

Incremental gross margin – incremental bad debt expense = adjusted gross margin

$32,000 - $4,800 = $27,200

Return on sales = ($27,200) / ($80,000)

Return on sales = 0.34, or 34%

Topic: Financing Current Assets

The optimal plan for Foster is the one that will maximize total contribution margin.

The total contribution for each option is calculated by taking the after-tax contribution margin on

annual revenue and subtracting all of the following: the after-tax bad debt, after-tax collection costs

and the interest cost on the investments in accounts receivable and inventory.

Total contribution margin = (after-tax contribution margin on annual revenue) – (bad debt expense +

collection costs)(1 – tax rate) – (interest cost on accounts receivable) – (interest cost on inventory)

After-tax contribution margin on annual revenue = (annual revenue(1 – variable cost ratio)(1 – tax

rate))

After-tax contribution margin on annual revenue = (annual revenue(1 – 0.8)(1 – 0.3))

After-tax contribution margin on annual revenue = (annual revenue(0.2)(0.7))

After-tax contribution margin on annual revenue = (annual revenue(0.14))

Total contribution margin = (annual revenue(0.14)) – (after-tax bad debt + after-tax collection costs)(1

– 0.3) – (interest cost on accounts receivable) – (interest cost on inventory)

(0.15)($50,000)

Contribution margin for Plan B = $18,000

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Section C: Corporate Finance

The contribution margin for Plan B is the highest of the four options.

(0.15)($40,000)

Contribution margin for Plan A = $17,600.

(0.15)($60,000)

Contribution margin for Plan C = $16,300

(0.15)($70,000)

Contribution margin for Plan D = $12,500

Topic: Financing Current Assets

The optimal plan for Harson is the one that maximizes total contribution margin.

Total contribution margin = (contribution margin on annual revenue) – (bad debt expense) –

(collection costs) – (interest income) – (interest costs on accounts receivable and inventory)

Contribution margin on annual revenue = (annual revenue)(1 – 0.80)

Contribution margin on annual revenue = (0.2)(annual revenue)

Total contribution margin = (0.2)(annual revenue) – (bad debt expense) – (collection costs) – (interest

income) – (interest costs on accounts receivable and inventory)

Contribution margin for Plan B = $2,600 – $250 – (0.1)($4,300)

Contribution margin for Plan B = $2,350 – $430 = $1,920

This is the highest of the four options.

Contribution for Plan A = $2,400 – $200 – (0.1)($3,500)

Contribution for Plan A = $2,200 – $350 = $1,850.

Contribution for Plan C = $2,800 – $550 - (0.1)($6,000)

Contribution for Plan C = $2,250 – $600 = $1,650

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Section C: Corporate Finance

Contribution for Plan D = $2,550 – $750 = $1,800

Topic: Financing Current Assets

The average collection period is calculated as follows:

Average collection period = (360 days) / (accounts receivable turnover)

Accounts receivable turnover = (net sales) / (average accounts receivable

Accounts receivable turnover = ($18,600,000) / ($1,380,000) = 13.48 times per year

Therefore, the average collection period = (360 days) / 13.48 = 26.7 days

Topic: Financing Current Assets

The reduction in average collection time needed to justify the lock-box systems occurs when the

benefit of the system equals its cost.

The benefit is the interest freed up for the reduction in days of the average collection time, and can be

calculated as follows:

Where x = number of days

Benefit of freed up interest = (300 receipts per day)($2,500 per average receipt)(0.08)x

Benefit of freed up interest = 60,000x

The annual cost of the system is given as $90,000. This can be set equal to the benefit to determine

the point at which cost is equal to the benefit, as follows:

60,000x = 90,000

x = 1.50 days

Topic: Financing Current Assets

Feedback: The correct answer is: Collect $25,000 accounts receivable; use $10,000 to purchase

inventory and use the balance to reduce short-term debt.

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Section C: Corporate Finance

inventory purchases – $10,000 in cash spent) / ($165,000 – $15,000 to reduce short-term debt)

Current ratio, alternative d. = $210,000 / $150,000 = 1.4, which satisfies the loan covenant.

The reduction in short-term debt would lower the total cost of debt.

Current ratio, alternative a. = ($200,000 + $25,000) / ($165,000 + $25,000)

Current ratio, alternative a. = $225,000 / $190,000 = 1.184, which would violate the loan covenant.

Current ratio, alternative b. = ($200,000 + 425,000 increase in inventory) / ($165,000) = Current ratio,

alternative b. = $225,000 / $165,000 = 1.36, which satisfies the loan covenant, but would have no

effect on the total cost of debt.

Topic: Financing Current Assets

The total cost of ordering and carrying inventory, including discounts, is calculated as follows:

Total cost of ordering and carrying inventory, including discounts = (annual ordering cost) + (carrying

costs) + (lost discount)

Annual ordering costs = (number of orders per year)($200 cost per order)

Number of orders per year = (400 pounds usage / 50 pounds per order) = 8 orders

Average inventory = (50 / 2) = 25 pounds

Note: 4% = 6% (for orders of 80 pounds or more) – 2% (for orders between 30 and 79 pounds)

Total cost of ordering and carrying inventory, including discounts = (8)($200) + (25)($100) +

(0.04)(400)($500)

Total cost of ordering and carrying inventory, including discounts = $1,600 + $2,500 + $8,000

Total cost of ordering and carrying inventory, including discounts = $12,100

Topic: Financing Current Assets

The total unit carrying costs of the inventory are calculated as follows:

Total unit carrying costs of the inventory = (insurance cost per unit) + (lost interest on investment)

Total unit carrying costs of the inventory = ($15) +(lost interest on investment)

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Section C: Corporate Finance

Lost interest = (cost of capital)(invoice price) + ($20 freight & insurance on shipment)

Lost interest = (0.25)($400) + ($20)

Lost interest = (0.25)($420) = $105

Therefore, the total unit carrying costs of the inventory = $15 + $105 = $120

Topic: Financing Current Assets

The carrying cost of the inventory is calculated as follows:

Carrying cost of the inventory = (average inventory)(carrying cost %)(inventory cost) + (safety stock)

Safety stock = 2,400 gallons

Topic: Financing Current Assets

The optimal safety stock minimizes the total of the carrying costs of the level of safety stock and the

stockout costs for that level of safety stock.

Carrying costs, safety stock level = (number of units in safety stock)(holding cost % + cost of short-

term funds %)

Carrying costs, safety stock level = (number of units in safety stock)(4% + 10%)(product cost)

Carrying costs, safety stock level = (number of units in safety stock)(4% + 10%)($20)

Carrying costs, safety stock level = 2.80(number of units in safety stock).

Total costs of safety stock level of 1,500 units = 2.8(1,500) + 1,000 = 4,200 + 1,000

Total costs of safety stock level of 1,500 units = $5,200

This is the lowest cost of the four levels.

Total costs of safety stock level of 1,000 units = 2.8(1,000) + 3,000 = 2,800 + 3,000

Total costs of safety stock level of 1,000 units = $5,800

Total costs of safety stock level of 1,250 units = 2.8(1,250) + 2,000 = 3,500 + 2,000

Total costs of safety stock level of 1,250 units = $5,500

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Section C: Corporate Finance

Topic: Financing Current Assets

The EOQ is calculated as follows:

EOQ = square root of all of the following: [(2 times the cost per order)(sales) / (the carrying costs)]

EOQ = the square root of [2($10)(1,000) / (0.2(410)]

EOQ = the square root of 10,000

EOQ = 100 units

Topic: Financing Current Assets

The annual yield for each investment is calculated as follows:

Annual yield = [(interest) / (usable funds)](360 / Term)

The yield on the 90-day investment = [(0.05)(80) / (0.95)(80)](360 / 90) = 0.2105, or 21.05%. This

investment has the highest yield.

The yield on the 180-day investment = [(0.06)(75) / (0.94)(75)](360 / 180) = 0.1277, or 12.77%.

The yield on the 270-day investment = [(0.05)(100) / (0.95)(100)](360 / 270) = 0.0702, or 7.02%.

The yield for the 360 day investment = 10%.

Topic: Financing Current Assets

Lang will pay Mega Bank $1,400,000 in the 3rd quarter which will be comprised of $1,000,000 in

principal repayment, plus interest of $400,000, which is calculated as follows:

Interest, 3rd quarter = (0.08)($20,000,000)(3/12) = $400,000

Lang will pay Mega bank $1,380,0000 in the 4th quarter which will be comprised of $1,000,000 in

principal repayment, plus interest of $380,000, which is calculated as follows:

Interest, 4th quarter = (0.08)($20,000,000 – $1,000,000)(3/12) = $380,000

Payments in the 3rd and 4th quarter = $1,000,000 + $400,000 + $1,000,000 + $380,000

Payments in the 3rd and 4th quarter = $2,780,000

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Section C: Corporate Finance

Topic: Financing Current Assets

Feedback: The correct answer is: Issue commercial paper, since it is approximately

$14,200 less expensive than the line of credit.

Net cost of issuing commercial paper = (interest expense) – (interest earned on excess funds in July) +

(interest earned on excess funds in September)

$8,000,000)(1/12) + (0.04)($12,000,000 - $10,000,000)(1/12)

Net cost of line of credit = (interest for July) + (interest for August) + (interest for September

(0.085)($10,000,000)(1/12)

Net cost of line of credit = $133,333 + $70,833 = $204,166

Difference between line of credit and commercial loan costs = $204,166 - $190,000

Difference between line of credit and commercial loan costs = $14,166

Line of credit is $14,166 higher than the commercial paper option.

$14,166 rounds up to approximately $14,200.

Topic: Financing Current Assets

The net annual savings would be the amount of the discounts taken, less the interest on the bank loan.

Discounts taken = (0.01)($25,000)(2 times per month)(12 months) = $6,000

Interest on the bank loan = ($25,000)(1 - 0.01)(4,750)(0.10)(30/360)(24 loans) = $4,950, since each

loan would have to cover the 30 days between the 15 day discount period and the 45th day due date.

Topic: Financing Current Assets

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Section C: Corporate Finance

The annual interest rate = [(interest)/(usable funds)] [(360) / (payment date – discount date)]

Annual interest rate = [2 / (100 – 2)][(360) / (45 + 5 – 10)]

Annual interest rate = (2/98)(360/40) = 0.1836, or 18.4%

Topic: Financing Current Assets

The effective annual interest rate cost = (interest) / (usable funds) (360/(payment date – discount date)

Effective interest rate = [3 / (100 – 3)][(360 )/ (90 – 10)]

Effective interest rate = (3 / 97)(360 / 80) = 0.139or 13.9%

Topic: Financing Current Assets

The effective annual interest rate = (interest)/(usable funds).

Usable funds = (1 – discount rate)

Usable funds = (1 – 0.12) = 0.88

Topic: Financing Current Assets

Since the loan is a discounted note, Gates has to borrow as follows:

Amount to borrow = ($300,000) / (1 – 0.09 discount rate)

Amount to borrow = ($300,000) / (0.91) = $329,670.32, or roughly $329,670.

Topic: Financing Current Assets

In order to cover the loan needs and the compensating balance, Keller would have to borrow as

follows:

Amount to borrow = ($150,000) / (1 – 0.15 compensating balance need)

Amount to borrow = ($150,000) / (0.85)

Amount to borrow = $176,470.58, or roughly $176,471.

Topic: Financing Current Assets

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Question Answers & Explanations CMA Part 3 –Strategic Management

Section C: Corporate Finance

The effective interest rate of 10.31%, or 0.1031 is equal to the interest on the loan divided by the

usable funds.

0.1031 = [$100,000,000(0.10)] / ($100,000,000 – x), where x = the compensating balance.

So,

$10,310,000 - 0.1031x = $10,000,000

0.1031x = $310,000

x = $3,006,789.50, or approximately $3,000,000.

Topic: Financing Current Assets

The effective annual interest rate is calculated as follows:

Effective annual interest rate = (interest) / (usable funds)

Effective annual interest rate = (0.07)($100,000) / [($100,000)(1 – 0.2 compensating balance

requirement)]

Effective annual interest rate = $7,000 / ($100,000)(0.8) = $7,000/$80,000

Effective annual interest rate = 0.0875, or 8.75%

Topic: Financing Current Assets

The effective annual interest rate is calculated as follows:

Effective annual interest rate = (interest) / (usable funds), or

0.1025 = ($100,000,000)(0.1) / ($100,000,000 – x), where x = the compensating balance.

So,

$10,250,000 - 0.1025x = $10,000,000

0.1025x = $250,000

x = $2,439,024.30 or roughly $2,440,000

Topic: Financing Current Assets

In the first quarter, Frame will pay interest of $200,000 and commitment fees of $12,500, which are

calculated as follows:

Commitment fees, first quarter = ($20,000,000 – $10,000,000)(0.005)(1/4) = $12,500

Total of interest and commitment fees = $200,000 + $12,500 = $212,500

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Section C: Corporate Finance

For the second and third quarters, Frame will pay interest of $800,000, which is calculated as follows:

Interest, second and third quarters = ($20,000,000)(0.08)(1/2) = $800,000

In the fourth quarter, Frame will pay interest of $100,000 and commitment fees of $18,750, which are

calculated as follows:

Interest, fourth quarter = ($5,000,000)(0.08)(1/4) = $100,000

Commitment fees, fourth quarter = ($20,000,000 – $5,000,000)(0.005)(1/4)

Commitment fees, fourth quarter = ($15,000,000)(0.00125) = $18,750

Total of interest and commitment fees = $100,000 + $18,750 = 118,750

Topic: Financing Current Assets

The effective annual interest rate is calculated as follows:

Effective annual interest rate = (interest) / (usable funds)

Effective annual interest rate = (0.08)($100,000,000) / ($100,000,000 – $5,000,000)

Effective annual interest rate = $8,000,000 / $95,000,000 = 0.0842, or 8.42%.

Topic: Financing Current Assets

The maximum annual expense that Garner could incur for this project would be equal to the project’s

expected benefit.

Expected benefit is 4 months’ interest on the funds freed up, adding 3 days to the disbursement

schedule.

Expected benefit = [$1,500,000(3 days)(0.04)(4/12)] + [$1,500,000(3 days)(0.07)(8/12) = 210,000]

Expected benefit = $60,000 + $210,000 = $270,000

Topic: Financing Current Assets

Mandel will have the following amount to invest:

January (beginning balance), for 1 month = $2,000,000

February, for 1 month = $2,000,000 beginning balance for January + $2,000,000 in January inflows =

$4,000,000

March, for 1 month = $4,000,000 from January + $1,000,000 in February inflows = $5,000,000

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Section C: Corporate Finance

Interest = ($11,000,000)(0.04)(1/12) = $36,667

Mandel will have to borrow $3,000,000 at the end of April ($5,000,000 from January and February -

$5,000,000 outflow in March - $3,000,000 outflow in April) for one month and will have to borrow an

additional $2,000,000 at the end of May to cover May outflows for one month.

Interest = ($3,000,000)(0.08)(1/12) + ($5,000,000)(0.08)(1/12)

Interest = ($8,000,000)(0.08)(1/12) = $53,333

Therefore, the net interest paid = $53,333 – $36,667 = $16,666, or approximately $17,000.

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Section D: Decision Analysis

Topic: Relevant Data Concepts

Feedback: The correct answer is: relevant because it is a decrease in cash outflow.

The $50,000 trade-in allowance decreases the initial investment in the project and, therefore, is

relevant.

Topic: Cost/Volume/Profit Analysis

The price Gardener should charge for KT-6500 is calculated as follows:

Price for KT-6500 = (unit variable costs) + (lost contribution margin on the units of XR-2000 that

would have to be foregone / units of KT-6500)

Price for KT-6500 = $50 + (lost contribution margin on the units of XR-2000 that would have to be

foregone / units of KT-6500)

The production of 1,000 units of KT-6500 would require 3,000 machine hours

(3 hours per unit)(1,000 units) = 3,000 machine hours

The 3,000 hours would reduce the production and sale of XR-2000 by 750 units (3,000 hours divided

by 4 hours per unit = 750 units).

The XR-2000 unit contribution margin = ($105 - $24 - $10 - $5 + $4) = $62

Lost contribution, in total = (number of units)(contribution margin per unit)

Lost contribution, in total = (750 units)($62) = $46,500

Lost contribution, on a per unit basis = ($46,500) / 1,000 units = $46.50 per unit of KT-6500.

Therefore, the minimum unit price that Gardener should charge LJB to manufacture 1,000 units of

KT-6500 = $50 + $46.50 = $96.50

Topic: Cost/Volume/Profit Analysis

If Segment B is closed, then Parklin would gain $13,000, which is calculated as follows:

Effect of closing Segment B = ($1,500 in B’s fixed cost of goods sold) + ($8,500 in B’s variable cost

of goods sold) + ($3,000 in B’s variable selling and administrative) = $13,000

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Section D: Decision Analysis

The closing would cause a reduction in sales of $15,000, resulting in a decrease in profits of $15,000 –

$13,000 = $2,000.

Topic: Cost/Volume/Profit Analysis

Contribution margin = (selling price per unit – variable costs per unit)(volume)

Contribution margin, approach Z = ($32 – $30)(14,000 units) = $28,000

Contribution margin, approach X = [($36 – (0.1 commission)($36) – $30)](10,000 units)

Contribution margin, approach X = ($2.40)(10,000) = $24,000

Contribution margin, approach Y = [($38 – (0.1 commission)($38) – $30)](12,000 units) – $30,000

advertising

Contribution margin, approach Y = ($4.20)(12,000) – $30,000 = $20,400

Topic: Cost/Volume/Profit Analysis

The operating income for the sale of 14 units is calculated as follows:

Operating income, 14 units = (price – variable cost)(14 units) – fixed costs

Operating income, 14 units = ($100,000 - $45,000)(14) - $600,000 = $170,000

This volume produces the highest operating income for Parker.

Operating income, 8 units = (price – variable cost)(8 units) – fixed costs

Operating income, 8 units = ($100,000 - $50,000)(8 units) - $400,000 = $0

Operating income, 10 units = (price – variable cost)(10 units) – fixed costs

Operating income, 10 units = ($100,000 - $50,000)(10 units) - $400,000 = $100,000

Operating income, 17 units = (price – variable cost)(17 units) – fixed costs

Operating income, 17 units = ($100,000 - $45,000)(17 units) - $800,000 = $135,000

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Section D: Decision Analysis

Topic: Cost/Volume/Profit Analysis

The maximum net profit that Elger can earn can be calculated as follows:

Maximum net profit = (1 – tax rate)(sales – variable costs – fixed costs)

Maximum net profit = (1 – 0.4)[($12)(40,000) – ($8)(40,000) – $48,000]

Maximum net profit = 0.6($480,000 – $320,000 - $48,000)

Maximum net profit = 0.6($112,000) = $67,200

Topic: Cost/Volume/Profit Analysis

Dayton’s net income is calculated as follows:

Net income = (1 – tax rate)[(sales – variable costs – fixed costs)]

Net income = (1 – 0.5)[($10)(30,000) – ($7)(30,000) – $42,000]

Net income = 0.5($300,000 - $210,000 – 42,000)

Net income = 0.5($48,000) = $24,000

Topic: Cost/Volume/Profit Analysis

Raymund’s monthly operating income is calculated as follows:

Operating income = sales – variable costs – fixed costs

Sales = $100,000

Current unit variable costs = ($65,000 / 5,000) = $13 per unit

Proposed unit variable costs = $13 - $5 reduction per unit = $8 per unit

Variable costs, proposed = ($8)(5,000 units) = $40,000

Operating income = $100,000 - $40,000 – $50,000 = $10,000

Topic: Cost/Volume/Profit Analysis

The total relevant costs associated with the manufacture of ice-makers is as follows:

Total relevant costs = (unit variable manufacturing costs)(number of units) + (any avoidable fixed

costs)

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Section D: Decision Analysis

Unit variable manufacturing costs = (direct materials + direct labor + variable overhead)

Unit variable manufacturing costs = ($7 + $12 + $5) = $24

Therefore, the relevant costs to manufacture the ice-makers = ($24)(20,000 units) + ($6)(20,000 units)

Topic: Cost/Volume/Profit Analysis

Feedback: The correct answer is: variable cost ratio of 32% and operating income of

$9,600,000.

The variable cost ratio (VCR) = unit variable costs as a percent of selling price.

Unit variable costs = (0.8)($60) = $48

Operating income = $150(175,000 units) - $48(175,000 units) – fixed costs

Operating income = $102(175,000) – fixed costs

Operating income = $17,850,000 – fixed costs

Fixed costs of $60 per unit are based upon 150,000 units.

Therefore, total fixed costs = $60(150,000) - ($750,000 reduction)

Total fixed costs = $9,000,000 – $750,000

Total fixed costs = $8,250,000

Operating income = $17,850,000 – $8,250,000 = $9,600,000

Topic: Cost/Volume/Profit Analysis

Feedback: The correct answer is: No, the machine-related cost of producing each unit

is $.67.

The machine-related cost per unit is calculated as follows:

Machine-related cost per unit = (cost of machine) / (useful life in unit)

Machine-related cost per unit = ($800,000) / (1,200,000 units) = $0.67 per unit

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Section D: Decision Analysis

Topic: Cost/Volume/Profit Analysis

Contribution per machine hour is calculated as follows:

Contribution per machine hour = (unit contribution margin)/(machine hours per unit)

CMU, Product A = ($100 – $63) = $37

Product A’s contribution per machine hour = $37 / 2 hours = $18.50 per hour.

The CMU for Product B = ($80 - $56) = $24

Product B’s contribution per machine hour = $24 / 1.5 hours = $16.00 per hour.

Topic: Cost/Volume/Profit Analysis

Feedback: The correct answer is: Market price of $4.05 per lb.; Purchase price of $3.40 per lb.

Decision making focuses on the current situation and the future situation. The current market price of

$4.05 per lb is relevant for decision making. The previous purchase price of $3.40 per lb is a sunk,

historical cost and is therefore irrelevant to decision making.

Topic: Cost/Volume/Profit Analysis

Feedback: The correct answer is: Continue to product and market this product.

The lawn fertilizer has a positive unit contribution margin of $2.50, which is the difference between its

selling price of $18.50 and the $16 in unit variable costs.

Unit variable costs = ($12.25 + $3.75) = $16.

The $4 per unit of fixed overhead cost is an irrelevant allocation that would continue regardless of the

production and sale of the lawn fertilizer.

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Section D: Decision Analysis

Topic: Cost/Volume/Profit Analysis

The costs relevant to the decision to produce or not to produce the new product total $25,000, and are

comprised of the $20,000 cost of materials and the $5,000 cost of labor. The costs associated with the

old machine are irrelevant; they are sunk, historical costs.

Topic: Cost/Volume/Profit Analysis

Variable expenses are calculated as follows:

Variable expenses = (1 – contribution margin ratio)(sales amount)

Variable expenses = 0.55($30,000) = $16,500

Topic: Cost/Volume/Profit Analysis

Feedback: The correct answer is: 82,500 units and $9,250,000 of operating income.

The break-even point in units is calculated as follows:

Break-even (units) = (total fixed costs) / (unit contribution margin)

Total fixed costs = $55(150,000 units) = $8,250,000.

Breakeven point (units) = $8,250,000 / ($160 – $60) = $8,250,000 / $100 = 82,500 units.

Operating income = ($100)(175,000 units) - $8,250,000 = $17,500,000 – $8,250,000

Operating income = $9,250,000

Topic: Cost/Volume/Profit Analysis

The difference in operating income is calculated as follows:

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Section D: Decision Analysis

Difference in operating income = $13,500

Topic: Cost/Volume/Profit Analysis

Contribution per machine hour is calculated as follows:

Contribution per machine hour = (unit contribution margin) / (machine hours per unit)

The CMU for Product A = ($100 – $63) = $37

Product A’s contribution per machine hour = $37 / 2 hours = $18.50 per machine hour.

The CMU for Product B = ($80 - $56) = $24

Product B’s contribution per machine hour = $24 / 1.5 hours = $16.00 per hour.

The maximum total contribution margin that Cervine can generate in the coming year is calculated as

follows:

Maximum total contribution margin = (10,000 units of A)(2 hours per unit)($18.50 per hour) +

(13,333 units of B)(1.5 hours per unit)($16 per hour)

Maximum total contribution margin = (20,000 hours)($18.50) + (19,999.5 hours)($16)

Maximum total contribution margin = $370,000 + $319,992 = $689,992

It is not feasible to use the entire 20,000 hours remaining after the production of A in the production of

B.

(20,000 hours)(1.5 hours per unit) = 13,333.33 hours.

The volume would be rounded down to 13,333.

Topic: Cost/Volume/Profit Analysis

Contribution per machine hour is calculated as follows:

Contribution per machine hour = (unit contribution margin) / (machine hours per unit)

Unit contribution margin (CMU) = unit selling price – unit variable costs

Unit variable cost, crates = direct materials + direct labor + variable overhead + variable selling

Unit variable cost, crates = $5 + $8 + $2 + $1 = $16

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Section D: Decision Analysis

Crate’s contribution per machine hour = $4 / 2 hours = $2.00 per machine hour

Trunk’s contribution per machine hour = $8 / 4 hours = $2.00 per machine hour

The maximum total contribution margin that Lazar can generate in the coming year can then be

calculated as follows:

Maximum total contribution margin = ($2.00 per machine hour)(1,000,000 machine hours) =

$2,000,000

Topic: Cost/Volume/Profit Analysis

The operating profit is calculated as follows:

Operating profit = (contribution margin ratio)(total sales $) – fixed costs

Forecasted sales, current year = $500,000

Contribution margin ratio, year just ended = (sales – variable costs) / (sales)

Contribution margin ratio, year just ended = ($450,000 - $270,000) / ($450,000) = 0.4

Topic: Cost/Volume/Profit Analysis

The change in profit is equal to the increase in contribution margin of $1,000.

Topic: Cost/Volume/Profit Analysis

The operating profit is calculated as follows:

Operating profit = (contribution margin ratio)(sales) – fixed costs

Operating profit = (0.45)($30)(3,000 units) – $10,000 = $40,500 – $10,000

Operating profit = $30,500

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Section D: Decision Analysis

Topic: Cost/Volume/Profit Analysis

The computation of the breakeven requires an assumption regarding the mix of patrons. The logical

assumption regarding the mix would be based upon the projected average attendance per performance,

multiplied by the number of performances.

With these assumptions, the sales mix based on revenue would be:

Mr. Wonderful = (3,500)($12) = $42,000

That’s Life = (3,000)($20) = $60,000

All that Jazz = (4,000)($12) = $48,000

Total = $150,000.

Mr. Wonderful = $42,000 / $150,000 = 28%

That’s Life = $60,000 / $150,000 = 60%

All that Jazz = $48,000 / $150,000 = 32%

The breakeven would occur when total contribution margin is equal to fixed costs.

Contribution margin = (price per unit – variable cost per unit)(number of patrons)

Total fixed costs = $165,000 + $249,000 + $316,000 + $565,000 = $1,295,000

Let x = total patrons.

Contribution margin, That’s Life = ($15 – $1)(0.40)x

Contribution Margin, All that Jazz = ($20)(0.32)x

Add the contribution margins from all three productions to get total contribution margin:

Total contribution margin = $4.2x + $5.6x + $6.4x = $16.2x.

Now set the total contribution margin equal to the total fixed costs of $1,295,900

$16.2x = $1,295,000

x = 79,938.27, which rounds to 79,939 patrons.

Topic: Cost/Volume/Profit Analysis

The target volume is calculated as follows:

Target volume = (fixed costs + target operating profit) / (selling price per unit – variable costs per unit)

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Section D: Decision Analysis

Target volume = ($250,000 + $2,000,000) / ($100 - $75)

Target volume = $2,250,000) / $25 = 90,000 units

Topic: Cost/Volume/Profit Analysis

The computation of the target volume requires an assumption regarding the product mix. The logical

assumption is the estimated sales volumes.

The target volume would occur when total contribution margin is equal to the target operating income

of $161,200 or total contribution margin of $1,122,200 ($961,000 + $161,200).

[(price per unit – unit variable cost)(volume)] - fixed costs = total contribution margin

No. 109 sets: (30,000 / 45,000)($10 - $5.50)x

No. 145 sets: (75,000 / 45,000) ($15 - $8)x

No. 153 sets: ($20 - $14)x

(30,000 / 45,000)($10 - $5.50)x + (75,000 / 45,000) ($15 - $8)x + ($20 - $14)x = $1,122,200

$9x + $35x + $18x = $3,366,600

$62x = $3,366,600

x = 54,300 No.153 socket sets

Topic: Cost/Volume/Profit Analysis

This problem can be solved by setting up an equation and solving for the required sales amount, which

will be represented by the variable S.

S = required sales

[(0.3)(S) - $240,000](1 – 0.4) = (0.06)(S)

(0.3S – $240,000)(0.6) = .06S

0.18S – $144,000 = 0.06S

0.12S = $144,000

S = $1,200,000

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Section D: Decision Analysis

Topic: Cost/Volume/Profit Analysis

The number of copies required can be found by solving the following equation, where x equals the

number of copies:

Total sales – total variable costs – fixed costs + typesetting + depreciation expense + general and

administrative expenses + miscellaneous fixed costs = (return %)(total sales)

Total variable cost = (variable cost per unit, or VCU)(x) = VCU(x)

Fixed costs = development + typesetting + depreciation + general and administrative + miscellaneous

fixed costs

Fixed costs = $35,000 + $18,500 + $9,320 + $7,500 + $4,400 = $74,720

VCU = (printing and binding + sales staff commissions + bookstore commissions + royalties) /

(number of copies)

VCU = ($30,000 + $5,400 + $67,500 + $27,000) / (6,000 copies) = $129,900 / 6,000

VCU = $21.65 per copy

$45x – $21.65(x) - $74,720 = $9x

$36x – $21.65(x) = $74,720

$14.35x = $74,720

x = 5,206.97, which rounds to 5,207 copies.

Topic: Cost/Volume/Profit Analysis

The sales required for the 8% return on investments are calculated by using the following formula,

which sets the sales amount equal to the required return.

Sales required for 8% return on investment = [(contribution margin ratio)(sales – fixed costs)](1 – tax

rate)

Investment = $300,000

8% return on investment = (0.08)($300,000) = $24,000

Contribution margin ratio = (1 – variable costs) = (1 – 0.3) = 0.7

So,

$24,000 = [(0.7)(Sales) - $600,000](1 – 0.4)

$24,000 = [0.7Sales - $600,000](0.6)

$24,000 = (0.42Sales - $360,000)

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Section D: Decision Analysis

$384,000 = 0.42Sales

Sales = $914,285.71, which rounds to $914,286

Topic: Cost/Volume/Profit Analysis

Allow x to equal the total attendance Mr. Wonderful needs to earn a contribution of $210,000 after

tax.

[($18 - $3)x - $165,000](1 – 0.3) = $210,000

($15x - $165,000)(0.7) = $210,000

$15x – $165,000 = $300,000

$15x = $465,000

x = 31,000

Total attendance of 31,000 is needed in order to earn a contribution margin of $210,000 after tax.

Topic: Cost/Volume/Profit Analysis

Feedback: The correct answer is: 4,948 round cakes, 14,843 heart-shaped cakes.

The breakeven volume occurs when the contribution margin of the two types of cakes are equal to the

fixed costs of $94,000. Assume that the product mix is 3 heart-shaped cakes for each round cake, so

heart-shaped cakes account for ¾ of the product mix and round cakes account for ¼ of the product

mix.

Unit contribution margin, round cake = $12 - $8 = $4

Unit contribution margin, heat-shaped cake = $20 - $15 = $5

Let x = total volume, and an equation can be created to set contribution margins for the two cakes

equal to total fixed costs, as follows:

cakes)(product mix, hearts)(total volume) = total fixed costs

$4x + $15x = $376,000

$19x = $376,000

x = 19,790 total cakes

(actually, it’s 19,791 total cakes, since ¼(19,790) = 4,947.5 rounded to 4,948 for round cakes and ¾

(19,790) = 14,842.5 rounded to 14,843 for heart-shaped cakes.

4,948 round cakes + 14,843 heart-shaped cakes = 19,791 total cakes

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Section D: Decision Analysis

Topic: Cost/Volume/Profit Analysis

Contribution margin = price – variable costs

Eagle would maximize contribution margin by maximizing contribution per pound of raw material.

The contribution margins per unit would be:

Contribution margin, Product X = ($100 – $80) = $20

Contribution margin, Product Y = ($130 – $100) = $30

Contribution per pound, Product X = $20 / 4 pounds = $5 per pound

Contribution per pound, Product Y = $30 / 10 pounds = $3 per pound

Therefore, Eagle would produce 250 units of Product X (1,000 lbs available)/(4 lbs per unit).

Topic: Cost/Volume/Profit Analysis

If the costs to process a product further are less than the change in the market value from processing,

the product should be processed further. If the process costs are greater than the change in market

value from processing, then the product should be sold at split-off.

Mononate should be sold at split-off, since the $125,000 in processing costs for Mononate are greater

than the change in market value of $120,000 from processing.

Cost from processing, Mononate = (sales price after processing) – (sales price at split-off)

Cost from processing, Mononate = (40,000 gallons)($10) – (40,000 gallons)($7)

Cost from processing, Mononate = $120,000

Beracyl should be processed further, since the $115,000 processing costs are less than the change in

market value of $180,000 from processing.

The $115,000 cost from processing Beracyl is calculated as follows:

Cost from processing, Beracyl = (60,000 gallons)($18) – (60,000 gallons)($15)

Cost from processing, Beracyl = $1,080,000 - $900,000 = $180,000

Topic: Cost/Volume/Profit Analysis

Total contribution margin in dollars is calculated as follows:

Total contribution margin = sales – variable costs

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Section D: Decision Analysis

The total contribution margin for Whitman after discontinuing the Restaurant segment would be 95%

of the Merchandise segment’s current contribution, plus 95% of the Automotive segment’s current

contribution

= (0.95)($500,000 - $300,000) + (0.95)($400,000 - $200,000)

= $190,000 + $190,000 = $380,000

Topic: Cost/Volume/Profit Analysis

Contribution margin ratio = (sales – variable costs) / (sales)

The ratio for Merchandise = ($500,000 – $300,0000) / $500,000 = 40%.

The ratio for Automotive = ($400,000 – $200,000) / $400,000 = 50%.

The ratio for Restaurants = ($100,000 - $70,000) / $100,000 = 30%.

Topic: Marginal Analysis

The appropriate purchase price would occur when the price for 30,000 units is equal to the variable

manufacturing costs plus the avoidable fixed costs.

P(units) = (variable manufacturing costs) + (avoidable fixed costs)

Where P = purchase price

Units = 30,000

Variable manufacturing costs = ($11)(30,000 units) = $330,000

Avoidable fixed costs = (0.6)($150,000) = $90,000

30,000 P = $420,000

P = $14.00

Topic: Marginal Analysis

Feedback: The correct answer is: Make 30,000 units of Product A, utilize the remaining

capacity to make Product B, and outsource the remainder.

Lark would pick the option that maximizes it contribution margin. Alternative a. provides the highest

contribution margin.

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Section D: Decision Analysis

Alternative a. consists of 30,000 units of Product A with a unit contribution margin of $45 per unit

($75 -$30), for a total contribution margin of ($45)(30,000 units) = $1,350,000.

Since there are 160,000 total machine hours available, 30,000 units of Product A would consume

90,000 machine hours (30,000 units)(3 hours per unit) and 70,000 machine hours would still be

available to manufacture Product B.

The 70,000 hours remaining can produce 14,000 units (70,000 machine hours / 5 hours per unit) of

Product B with a total contribution margin of $1,078,000 ($125 – $48)(14,000 units). The remaining

6,000 units of Product B would be outsourced to produce a contribution of $390,000 ($125 –

$60)(6,000 units).

The total contribution for Alternative a. = $1,350,000 + $1,078,000 + $390,000

Total contribution for Alternative a. = $2,818,000

Alternative b. consists of 25,000 units of Product A with a unit contribution margin of $45 per unit

($75 - $30), for a total contribution margin of ($45)(25,000 units) = $1,125,000

Since there are 160,000 total machine hours available, 25,000 units of Product A would consume

75,000 machine hours (25,000 units)(3 hours per unit) and 85,000 machine hours would still be

available to manufacture Product B.

The 85,000 hours remaining can produce 17,000 units (85,000 machine hours / 5 hours per unit) of

Product B with a total contribution margin of $1,309,000 ($125 – $48)(17,000 units). The remaining

3,000 units of Product B would be outsourced to produce a contribution of $195,000 ($125 –

$60)(3,000 units).

The remaining 5,000 units of Product A would be outsourced to produce a contribution of $150,000

($75 - $45)(5,000 units).

The total contribution for Alternative b. = $1,125,000 + $1,309,000 + $195,000 + $150,000 =

$2,779,000

Alternative c. consists of 20,000 units of Product A with a unit contribution margin of $45 per unit

($75 - $30), for a total contribution margin of ($45)(20,000 units) = $900,000.

Since there are 160,000 total machine hours available, 20,000 units of Product A would consume

60,000 hours (20,000 units)(3 hours per unit) and 100,000 machine hours would still be available to

manufacture Product B.

The 100,000 hours remaining can produce 20,000 units (100,000 machine hours / 5 hours per unit) of

Product B (which is the entire need of Product B) with a total contribution margin of $1,540,000 ($125

– $48)(20,000 units).

The remaining 10,000 units of Product A would be outsourced to produce a contribution of $300,000

($75 – $45)(10,000 units) = $300,000.

The total contribution for Alternative c. = $900,000 + $1,540,000 + $300,000 = $2,740,000

Alternative d.’s contribution margin = ($45)(30,000 units) for Product A + ($77)(20,000 units) for

Product B – $150,000 to rent the additional capacity

Alternative d.’s contribution margin = $1,350,000 + $1,540,000 – $150,000

Alternative d.’s contribution margin = $2,749,000

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Section D: Decision Analysis

Topic: Marginal Analysis

The minimum per unit selling price will be equal to the unit variable manufacturing costs. Total

variable manufacturing costs are $50,000 for 5,000 units, which means that the variable manufacturing

costs on a per unit basis are $10. The variable selling costs and fixed costs will not be incurred for this

one-time-only order and are therefore irrelevant.

Topic: Marginal Analysis

Feedback: The correct answer is: Continue operating the Oak Division as

discontinuance would result in a $6,000 decline in operating profits.

The discontinuance of the Oak Division will result in a $6,000 decline in operating profits. The

discontinuance of the Oak Division will cause a gain of $79,000, which is calculated by taking the

$72,000 in variable costs and adding one half of the fixed costs of $14,000 to it ($72,000 +

(0.5)($14,000) = $79,000).

However, the discontinuance will cause a loss in sales of $85,000. The resulting decline in profit will

then be $85,000 – $79,000 = $6,000

Topic: Marginal Analysis

Feedback: The correct answer is: Produce XT internally and purchase RP.

Aspen’s goal would be to minimize costs, so producing XT internally and purchasing RP will result in

the lowest cost.

Option a. would cost $1,020,000, which is made up of the costs of both XT and RP as follows:

Cost of XT, produced internally = (materials + direct labor + variable overhead)(number of units)

Cost of XT, produced internally = ($37 + $12 + $6)(12,000) = ($55)(12,000) = $660,000

Cost of RP, purchased = (purchase cost)(number of units) = ($45)(8,000) = $360,000

Total cost of XT and RP, option a = $660,000 + $360,000 = $1,020,000

Cost of RP, produced internally = (materials + direct labor + variable overhead)(number of units)

Cost of RP, produced internally = ($24 + $13 + $3)(8,000) = ($40)(8,000) = $320,000

Cost of XT, purchased = (purchase cost)(number of units) = ($60)(12,000) = $720,000

Total cost of RP and XT, option b = $320,000 + $720,000 = $1,040,000

Cost of RP, purchased = (purchase cost)(number of units) = ($45)(8,000) = $360,000

Cost of XT, purchased = (purchase cost)(number of units) = ($60)(12,000) = $720,000

Total cost of RP and XT, option c = $360,000 + $720,000 = $1,080,000

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Section D: Decision Analysis

Option d. is not feasible. XT would use the capacity of 12,000 hours (12,000 units at 1 hour each)

Topic: Marginal Analysis

The purchase costs are calculated as follows:

Purchase costs = ($28 per unit)(20,000 units) = $560,000

Make cost = (unit variable costs, including direct materials, direct labor, and variable

overhead)(number of units) + (fixed overhead) + (lost contribution margin)

Unit variable costs = ($7 + $12 + $5)(20,000) = $480,000

Fixed costs = ($6)(20,000) = $120,000

Lost contribution margin = (contribution margin ratio)(contribution margin lost)

Lost contribution margin = (1 – 0.6)($80,000) = $32,000

Topic: Marginal Analysis

To solve this problem, it is necessary to compare the new contribution margin to the original

contribution margin.

Original contribution margin = (price per unit – variable costs per unit)(number of units)

Variable costs per unit = (direct materials + direct labor + variable overhead + variable selling)

Variable costs per unit = ($5 + $8 + $3 + $1) = $17 per unit

Original contribution margin = ($20 - $17)(500,000 units) = $1,500,000

New contribution margin = (price per unit – variable costs per unit)(number of units)

Variable costs per unit = (direct materials + direct labor + variable overhead + variable selling)

New variable overhead cost = (original variable overhead) + (incremental increase in variable

overhead)

The problem states that variable overhead is consumed at a rate of $3 for every two machine hours.

The variable overhead is increased by 1.5 times, hence the incremental increase in variable overhead

would be: ($3/2)(1.5) = $2.25

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Section D: Decision Analysis

New contribution margin = $3.75(500,000) = $1,675,000.

The change between the new contribution margin and the original contribution margin is:

Change in contribution margin = $1,675,000 – $1,500,000 = $125,000 increase

Topic: Marginal Analysis

BCC’s lowest possible bid can be calculated as follows:

Lowest possible bid = (materials + direct labor + variable overhead + incremental administrative costs)

Direct labor cost = (12 hours)($20 per hour) = $240

Variable overhead = (12 hours)($2 per hour) = $24

Topic: Marginal Analysis

Feedback: The correct answer is: Process Product C further but sell Product B at the

split-off point.

A product should be processed further if the change in the market price from processing exceeds the

additional processing costs.

Product B can be sold at split-off for $5.50(20,000) = $110,000 and after further processing for

$8(20,000) = $160,000, for an increase of $50,000 ($160,000 - $110,000 = $50,000), which is less

than the additional processing costs of $60,000. Therefore, Product B should be sold at split-off.

Product C can be sold at split-off for $10.25(70,000) = $717,500, and after further processing for

$12.50(70,000) = $875,000, for an increase of $157,500 ($875,000 – $717,500 = $157,500), which is

greater than the additional processing costs of $140,000.

Topic: Marginal Analysis

Feedback: The correct answer is: The Freezer Department's manufacturing plan should include

5,000 units of Model A and 4,500 units of Model B.

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Section D: Decision Analysis

Synergy would want to maximize the contribution per machine hour, multiplied by the 28,000

machine hours available.

The contribution per machine hour for each product can be calculated as follows:

Contribution per machine hour = (outside price – product’s unit variable costs) / (number of machine

hours required to make it)

Contribution per machine hour, Model A = ($21 – $10 variable direct costs – $5 variable overhead) /

(5 / 2.5)

Contribution per machine hour, Model A = $6 / 2 hours = $3.00 per machine hour

Contribution per machine hour, Model B = ($42 – $24 variable direct costs – $10 variable overhead) /

(10 / 2.5)

Contribution per machine hour, Model B = $8 / 4 hours = $2.00 per machine hour

Contribution per machine hour, Model C = ($39 – $20 variable direct costs – $15 variable overhead) /

(15 / 2.5)

Contribution per machine hour, Model C = $4 / 6 hours = $0.67 per machine hour

Based on this information about contribution per machine hour, Synergy should:

- First produce 5,000 units of Model A (the highest contribution margin per machine hour) using

5,000(2) = 10,000 machine hours

- Then produce 4,500 units of Model B (the next highest contribution margin per machine hour)

using 4,500(4) = 18,000 machine hours

- The two models would use the entire capacity of 28,000 machine hours (10,000 + 18,000), so

no additional products could be produced.

Topic: Marginal Analysis

The profit on the new doll is calculated as follows:

Profit on new doll = (1 – tax rate)[(sales revenue – variable costs – fixed costs)

Sales revenue = ($100)(10,000 units) = $1,000,000

Variable costs = ($60)(10,000 units) = $600,000

Fixed costs = $456,000

Profit on new doll = (0.7)(-$56,000) = -$39,200, which is a loss of $39,200

Topic: Marginal Analysis

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Section D: Decision Analysis

If Johnson accepts the special order, they will gain $112,500 ($7.50 price multiplied by the 15,000

volume). The order will cost $75,000 ($5 variable manufacturing cost multiplied by the 15,000

volume).

Therefore, the increase in operating income is calculated as follows:

Increase in operating income = $112,500 – $75,000 = $37,500

Topic: Marginal Analysis

The contribution for Robo Division is calculated as follows:

Contribution, Robo Division = (sales – its own variable costs – transfer price)

Contribution, Robo Division = ($8,000,000 - $4,800,000 - $3,700,000) = -$500,000

Contribution, GMT Division = (sales – Robo’s variable costs – Cross’ variable costs)

Contribution, GMT Division = ($8,000,000 – $4,800,000 - $1,500,000) = $1,700,000

Topic: Cost-Based Pricing

The price (p) of DMA is computed by using the following formula:

(p – costs)(number of units) = (return in investment %)(investment)

(p - $300)(10,000) = [(0.2)($20,000,000)]

p - $300 = $4,000,000 / 10,000

p = $700

Markup percentage of full product cost = ($700 - $300) / ($300) = $400/$300 = 1.333, or 133.3%.

Topic: Cost-Based Pricing

The full cost bid is calculated as follows:

Full cost bid = (1 + return %)(cost of materials + labor + variable overhead + fixed overhead +

incremental administrative costs)

Cost of materials = $500

Cost of labor = (17 hours)($20) = $340

Variable overhead = (17 hours)($2) = $34

Fixed overhead = (17 hours)($3) = $51

Incremental administrative costs = $8

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Section D: Decision Analysis

Topic: Cost-Based Pricing

The cost function for Almelo is as follows:

Cost function = $100,000 + $6x

where x = bookkeeping hours

Unit cost at 50,000 hours = $100,000 / 50,000 + $6 = $2 + $6 = $8 per hour

Given the price of $9, the mark-up level on cost = (price – cost) / (cost)

Mark-up level on cost = ($9 – $8) / ($8) = 1/8 = 0.125, or 12.5%

Topic: Cost-Based Pricing

The target price (p) is computed by using the following formula:

(total sales – total variable costs – total fixed costs)(1 – tax rate) = 15%(investment)

Total variable costs = (volume)(variable cost per unit) = (25,000)($200) = $5,000,000

Total fixed costs = $700,000

Investment includes both plant and working capital ($3,000,000 + $1,000,000 = $4,000,000

15,000p - $3,420,000 = $600,000

15,000p = $4,020,000

p = $268

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

The cash flow in year 5 of the project is calculated as follows:

Cash flow, Year 5 = (projected savings – depreciation expense)(1 – tax rate) + depreciation expense

Annual depreciation expense = (original cost + installation costs + freight and insurance costs) / useful

life)

Annual depreciation expense = ($90,000 + $4,000 + $6,000) / 5 years = $20,000 per year

Cash flow, Year 5 = $26,000

Topic: Discounted Cash Flow Analysis

The cash flow in period 3 is calculated as follows:

Cash flow, period 3 = (revenue – cash expenses – depreciation expense)(1 – tax rate) + depreciation

expense

Cash flow, period 3 = ($1,200,000 – $300,000 – depreciation expense)(1 – 0.4) + depreciation expense

Depreciation expense per period, equipment = $3,000,000 / 5 = $600,000

Total depreciation expense (building and equipment) = $800,000 per period.

Topic: Discounted Cash Flow Analysis

The annual cash flow from this investment is calculated as follows:

Annual cash flow = (net income + depreciation + interest expense

Annual cash flow = $192,000 + $70,000 + $8,000 = $270,000

In the discounted cash flow analysis used for capital budgeting, interest is considered in the

determination of the relevant discount rate and is not considered as part of the annual operating cash

flows.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

The cash flow in year 5 is calculated as follows:

Cash flow, Year 5 = (revenue – direct labor and materials cost – indirect costs)(1 – tax rate) +

(working capital reversal) + (salvage value) – (removal costs) – (tax effect on salvage value and

removal costs)

Direct labor and materials = (100,000 units)($65) = $6,500,000

Indirect costs = $500,000

Working capital reversal = $400,000

Salvage value = $300,000

Removal costs = $100,000

Tax effect on salvage value and removal costs = ($300,000 - $100,000)(0.4) = $80,000

Cash flow, Year 5 = (8,000,000 - $6,500,000 - $500,000)(1 - 0.4) + $400,000 + $300,000 – $100,000

– $80,000

Cash flow, Year 5 = $600,000 + $520,000 = $1,120,000

Topic: Discounted Cash Flow Analysis

The initial investment at time 0 is calculated as follows:

Initial investment, time 0 = (equipment purchase price + installation costs + additional working

capital)

Initial investment, time 0 = ($1,200,000 + $300,000 + $400,000) = $1,900,000

Topic: Discounted Cash Flow Analysis

The annual cash flow from the investment is calculated as follows:

Annual cash flow = (projected cash savings – change in depreciation)(1 – tax rate) + (change in

depreciation

Change in depreciation = $16,000 - $1,600 = $14,400

Annual cash flow = $14,000(0.6) + $14,400 = $8,400 + $14,400 = $22,800

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

The cash flow in year 1 is calculated as follows:

Cash flow, Year 1 = (annual savings – depreciation expense)(1 – tax rate) + depreciation expense

costs)(MACRS depreciation factor)

Annual depreciation expense = ($250,000 + $25,000) (0.2) = $55,000

Cash flow, Year 1 = $20,000(0.6) + $55,000 = $12,000 + $55,000 = $67,000

Topic: Discounted Cash Flow Analysis

The after-tax cash outflows at time 0 is calculated as follows:

After-tax cash outflow, time 0 = (cost of new equipment + installation and transportation costs +

working capital – proceeds from sale of old equipment – tax effect of sale of old equipment)

Working capital = ($30,000) – ($15,000) = $15,000

Tax effect of sale of old equipment = (proceeds from sale – book value)(tax rate)

Tax effect of sale of old equipment = ($80,000 - $100,000)(0.4) = -$8,000

Book value =

After-tax cash outflow, time 0 = $202,000

Topic: Discounted Cash Flow Analysis

The working capital investment is a $40,000 outflow at time 0 (= now) and a $40,000 inflow at time 5

(= end of year 5).

NPV of working capital at 12% = $40,000(0.567 PV lump sum i=12,n=5) – $40,000

NPV of working capital = -$17,320

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

Feedback: The correct answer is: inflow plus annual depreciation tax shield.

The relevant cash flow for Year 2 is calculated as follows:

Relevant cash flow, Year 2 = (operating cash flows – depreciation)(1 – 30% tax rate) + depreciation.

Topic: Discounted Cash Flow Analysis

The depreciation tax savings (or depreciation tax shield) is calculated by taking the after-tax present

value of the annual depreciation charges.

Depreciation tax shield = (0.4)($20,000)(4.355 PV annuity i=10,n=6)

Depreciation tax shield= (0.4)($20,000)(4.355) = $34,840

Topic: Discounted Cash Flow Analysis

Cash flow, Year 3, is calculated as follows:

Cash flow, Year 3 = (revenue – labor costs – material costs – fixed costs – depreciation expense)(1 –

tax rate) + depreciation expense

$500,000

Cash flow, Year 3 = $1,058,750.

Topic: Discounted Cash Flow Analysis

The cash flow in Year 5 is calculated as follows:

Cash flow, Year 5 = (after-tax operating cash flow) + (cash flows related to disposal of new

equipment)

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Section E: Investment Decisions

After-tax operating cash flow = (cash inflow – depreciation expense)(1 – 0.4) + (depreciation expense)

Depreciation expense, Year 5 = (equipment cost + installation and transportation costs)(depreciation

rate in year 5)

Depreciation expense = ($250,000 + $25,000)(0.145) = $39,875

After-tax operating cash flow = ($75,000 - $39,875)(0.6) + $39,875 = $60,950

Cash flow related to disposal of new equipment = (proceeds from sale) – (proceeds)(tax rate)

Cash flow related to disposal of new equipment = ($30,000) – ($30,000)(0.4) = $18,000

Topic: Discounted Cash Flow Analysis

The net tax impact in Year 2 is calculated as follows:

Net tax impact, Year 2 = (revenue – cash expenses – depreciation)(tax rate)

Depreciation expense, year 2 = (equipment cost)(year 2 MACRS rate)

Depreciation expense, year 2 = ($1,000,000)(0.32) = $320,000

Net tax impact, Year 2 = ($700,000 - $450,000 - $320,000)(0.4)

Net tax impact, Year 2 = -$28,000, which is a reduction in taxes.

Topic: Discounted Cash Flow Analysis

Net present value (NPV) is an approach that takes the initial investment and subtracts the present value

(PV) of the future cash flows, in order to arrive at a project’s net present value.

PV = ($9,000 cash flows)(3.240 PV of lump sum at i=9,n=4) = $29,160

Topic: Discounted Cash Flow Analysis

The initial investment is calculated as follows:

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Section E: Investment Decisions

accounts payable) – (proceeds from sale of existing equipment) + (tax effect of disposal of existing

equipment)

Net book value = $50,000 - $45,000 = $5,000

Tax effect of disposal of existing equipment = (tax rate)(proceeds from sale – net book value)

Tax effect of disposal of existing equipment = (0.4)($3,000 - $5,000) = -$800

Topic: Discounted Cash Flow Analysis

The amount related to the new asset’s depreciation that would be included in an NPV analysis would

be equal to the present value (PV) of the depreciation tax shield.

PV = (0.4)($600,000)(3,17) = $760,800

Topic: Discounted Cash Flow Analysis

The initial cash outflow at time 0 is calculated as follows:

Initial cash outflow = (cost of machine) + (installation costs) + (freight and insurance) – proceeds from

sale of existing machine + tax from sale of machine

Tax from sale of machine = (tax rate)(proceeds from sale – net book value)

Net book value, end of year 7 = (original cost)(% of life remaining)

Net book value, end of year 7 = ($50,000)(0.3) = $15,000

Tax from sale of machine = (0.4)($25,000 - $15,000) = $4,000

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Section E: Investment Decisions

Initial cash outflow = $79,000

Topic: Discounted Cash Flow Analysis

The cash flow in period 5 is calculated as follows:

Cash flow, period 5 = (operating cash flow, period 5)(1 – tax rate) + (proceeds from sale of land)(tax

rate) + (proceeds from sale of building)(tax rate) + (proceeds from sale of equipment)(tax rate)

Operating cash flow, period 5 = (revenue – cash expenses – building depreciation – equipment

depreciation)(1 – tax rate) + building depreciation expense + equipment depreciation expense

Building depreciation = $2,000,000 / 10 years = $200,000

Equipment depreciation = $3,000,000 / 5 years = $600,000

Operating cash flow, period 5 = ($1,200,000 - $300,000 - $200,000 - $600,000)(1 – 0.4) + $200,000 +

$600,000

Operating cash flow, period 5 = $860,000

Cash flow from sale of land = (proceeds from sale) – (proceeds – book value)(tax rate)

Cash flow from sale of land = $800,000 – ($800,000 - $500,000)(0.4)

Cash flow from sale of land = $680,000

Cash flow from sale of building = (proceeds from sale) – (proceeds – book value)(tax rate)

Cash flow from sale of building = ($500,000) – ($500,000 - $1,000,000)(0.4)

(Note: $1,000,000 = 50% of original cost of $2,000,000)

Cash flow from sale of building = ($500,000) – (-$200,000)

Cash flow from sale of building = $700,000

Cash flow from sale of equipment = (proceeds from sale) – (removal cost) – (proceeds – removal

cost)(tax rate)

Cash flow from sale of equipment = ($300,000) – ($50,000) – ($300,000 – $50,000)(0.4) Cash flow

from sale of equipment = $250,000 – ($250,000)(0.4) = $150,000

Topic: Discounted Cash Flow Analysis

The incremental cash flows for the first year are calculated as follows:

Incremental cash flows, Year 1 = (revenues – change in depreciation expense)(1 – tax rate) + (change

in depreciation expense)

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Section E: Investment Decisions

Change in depreciation is calculated by comparing the depreciation expense on the existing machine to

the depreciation expense on the new machine.

Depreciation on new machine = (original cost + installation cost + freight and insurance) / useful life

Depreciation on new machine = ($90,000 + $4,000 + $6,000) / 5 years = $20,000

Change in depreciation = ($20,000) – ($5,000) = $15,000

Incremental cash flows, Year 1 = ($15,000)(0.6) + $15,000

Incremental cash flows, Year 1 = $9,000 + $15,000 = $24,000

Topic: Discounted Cash Flow Analysis

The expected cash flow for year 3 is calculated as follows:

Expected cash flow, Year 3 = (revenue) – (direct labor and material costs) – (indirect costs) –

(depreciation expense) + (depreciation tax shield)

Revenue = (units)(sales price per unit) = (100,000)($80) = $8,000,000

Direct labor and material costs = (units)(unit cost) = (100,000)($65) = $6,500,000

Indirect costs = $500,000 (given)

Depreciation expense = (equipment cost + installation costs) / useful life

Depreciation expense = ($1,200,000 + $300,000) / 3 years = $500,000

Depreciation tax shield = (depreciation expense)(1- tax rate)

Depreciation tax shield = ($500,000)(1 – 0.4) = $300,000

Expected cash flow, Year 3 = $800,000

Topic: Discounted Cash Flow Analysis

Feedback: The correct answer is: $432,000 real and $444,960 nominal.

The real revenues for the second year are calculated as follows:

Real revenues, Year 2 = ($400,000)(1 + 0.08) = $432,000

The nominal revenues for the second year are calculated as follows:

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Section E: Investment Decisions

Nominal revenues, Year 2 = ($432,000)(1 + 0.03) = $444,960

Topic: Discounted Cash Flow Analysis

Nolan should choose the option with the lowest present value (PV).

The present value is the sum of the future cash flows.

This option has the lowest NPV, so it would be the best choice.

Topic: Discounted Cash Flow Analysis

The internal rate of return (IRR) is the discount rate at which the net present value (NPV) is equal to

zero.

For project A, the IRR, by interpolation = 18% + [(77)/(77 +26)](2%)

Project A, IRR = 18% + (154/103)% = 18% + 1.495% = 19.495%, or 19.5%

Project B, IRR = 24% + (60/41)% = 24% + 1.463% = 25.463%, or 25.5%

Topic: Discounted Cash Flow Analysis

The approximate annual interest rate Bell is paying is the internal rate of return on an initial inflow of

$30,000 coupled with a five-year annuity of $7,900 in cash outflows.

The internal rate of return (IRR) is the discount rate at which the net present value (NPV) is equal to

zero.

NPV = ($7,900)(f) - $30,000

Where: f = the present value of annuity factor at which i= IRR rate and n= 5

f = $30,000 / $7,900 = 3.797 (the present value of annuity at i=IRR, n=5).

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Section E: Investment Decisions

Using the present value of annuity table, and looking under the n=5 row, the number 3.791 appears in

the i=10% column.

Therefore, the approximate annual interest rate is 10%.

Topic: Discounted Cash Flow Analysis

The current contribution margin per year is calculated as follows:

Current annual contribution margin = (price per unit – variable cost per unit)(number of units)(1 – tax

rate)

Current annual contribution margin = ($100 – $70)(10,000)(1 – 0.4) = $30(10,000)(0.6)

Current annual contribution margin = $240,000

Revised contribution margin = (0.1)($70)(10,000)(0.6) = $42,000

The present value of the $42,000 increase = ($42,000)(5.216 present value of annuity i=14, n=10) =

$219,072 or approximately $219,000.

Topic: Discounted Cash Flow Analysis

Feedback: The correct answer is: The profitability index of Project B is greater than the profitability

index of Project A.

The profitability index (PI) for a project is calculated as follows:

PI = (net present value) / (initial investment), or

PI = NPV / I

NPV for Project A, at 10% = -$100,000 + ($40,000)(0.909 lump sum i=10, n=1) + ($50,000)(0.826

lump sum i=10, n=2) + ($60,000)(0.751 lump sum i=10, n=3)

NPV, Project A, at 10% = -$100,000 + $36,360 + $41,300 + $45,060 = $22,720

NPV for Project B, at 12% = -$150,000 + ($80,000)(0.893 lump sum i=12, n=1) + ($70,000)(0.797

lump sum i=12, n=2) + ($60,000)(0.712 lump sum i=12, n=3)

NPV for Project B, at 12% = -$150,000 + $71,440 + $55,790 + $42,720 = $19,950

Project B’s PI = $19,950 / $150,000 = 0.1333, which is less than Project A’s PI of 0.2272.

Topic: Discounted Cash Flow Analysis

Feedback: The correct answer is: $5,000 now and $20,000 per year at the end of each

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Section E: Investment Decisions

Wilcox would select the alternative with the highest net present value (NPV) computed at 8%.

NPV, alternative c. = $5,000 + ($20,000)(6.71 PV of annuity i=8, n=10)

NPV, alternative c. = $5,000 + ($134,200) = $139,200

This option has the highest NPV, and would therefore be selected.

i=8, n=10)

NPV, alternative d. = $5,000 + $31,235 + $92,600 = $128,835

Topic: Discounted Cash Flow Analysis

The after-tax cash flow in Year 5 is calculated as follows:

After-tax cash flow, Year 5 = (annual after-tax cash flow) + (salvage value) – (tax on salvage value)

Tax on salvage value = (salvage value)(tax rate)

Tax on salvage value = ($50,000)(0.4) = $20,000

After-tax cash flow, Year 5 = ($350,000) + ($50,000) – ($20,000)

After-tax cash flow, Year 5 = $380,000

NPV of project = (initial investment) + (sum of future cash flows)

NPV of project = (-$550,000) – ($500,000)(0.877 PV lump sum i=14, n=1) + ($450,000)(0.769 PV

lump sum i=14, n=2) + ($350,000)(0.675 PV lump sum i=14, n=3) + (0.592 PV lump sum i=14, n=4)

+ ($380,000)(0.519 PV lump sum i=14, n=5)

NPV of project = $(1,780)

Topic: Discounted Cash Flow Analysis

The net present value (NPV) of outsourcing the finishing work is calculated as follows:

NPV, outsourcing finishing work = (annual cash flow)(1 – tax rate)(PV annuity factor, i=10, n=5)

NPV, outsourcing finishing work = ($200,000)(1 – 0.4)(3.791)

NPV, outsourcing finishing work = ($200,000)(0.6)(3.791) = $454,920 cash outflow.

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

The cash inflow from the investment in the new machine for each of the five years is calculated as

follows:

Annual cash flow from investment = (annual savings – annual depreciation expense)(1 – tax rate) +

(annual depreciation expense)

Annual depreciation expense = (cost – trade-in allowance) / 5 year life

Annual depreciation expense = ($1,000,000 - $50,000) / 5 years = $190,000

Annual cash flow from investment = ($100,000 - $190,000)(1-0.4) + $190,000

Annual cash flow from investment = $136,000

The net present value (NPV)of acquiring the new finishing machine can now be calculated:

NPV, new machine = (initial investment) + (annual cash flow)(PV annuity factor, i=10, n=5)

NPV, new machine = (-$950,000) + ($136,000)(3.791) = -$434,424, which is a net cash outflow.

Topic: Discounted Cash Flow Analysis

The internal rate of return (IRR) is the discount rate at which the net present value (NPV) is equal to

zero. For the copy machine, the IRR, by interpolation = 8% + [(60)/(60 +40)](2%) = 8% +

(120/100)% = 8% + 1.2% = 9.2%, or approximately 9%.

Topic: Discounted Cash Flow Analysis

The revised NPV for the tax shield is calculated as follows:

PV of the after-tax depreciation at 20% = [(equipment cost)(tax rate)][(MACRS rate, year 1)(PV

factor, lump sum i=20, n=1) + (MACRS rate, year 2)(PV factor, lump sum i=20, n=2) + (MACRS

rate, year 3)(PV factor, lump sum i=20, n=3) + (MACRS rate, year 4)(PV factor, lump sum i=20,

n=4)]

(0.1481)(0.579) + (0.0741)(0.482)]

PV of the after-tax depreciation at 20% = ($400,000)[(0.2776389) + (0.308483) + (0.0857499) +

(0.035716)]

PV of the after-tax depreciation at 20% = ($400,000)(0.707588) = $283,035, which is approximately

$283,000

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Section E: Investment Decisions

Topic: Discounted Cash Flow Analysis

The net present value (NPV) of this project is calculated as follows:

PV of Year 0 cash flow = -$20,000

PV of Year 1 cash flow = $6,000(0.893 PV lump sum i=12, n=1) = $5,358

PV of Year 2 cash flow = $6,000(0.797 PV lump sum i=12, n=2) = $4,782

PV of Year 3 cash flow = $8,000(0.712 PV lump sum i=12, n=3) = $5,696

PV of Year 4 cash flow = $8,000(0.636 PV lump sum i=12, n=4) = $5,088

The sum of these cash flows, which is also the net present value of the project, is $924.

Topic: Discounted Cash Flow Analysis

The depreciation per year on the machine = $100,000, which is calculated by taking the purchase

value of $500,000 and dividing it by 5 years.

Annual cash flow = (pre-tax cash flow – deprecation expense)(1 – tax rate) + (depreciation expense)

Cash flow, Year 1 = (-$50,000)(0.6) + $100,000 = -$30,000 + $100,000 = $70,000

Cash flow, Year 2 = (-$50,000)(0.6) + $100,000 = -$30,000 + $100,000 = $70,000

Cash flow, Year 3 = (-$300,000)(0.6) + $100,000 = -$180,000 + $100,000 = $280,000

Cash flow, Year 4 = (-$300,000)(0.6) + $100,000 = -$180,000 + $100,000 = $280,000

Cash flow, Year 5 = (-$300,000)(0.6) + $100,000 = -$180,000 + $100,000 = $280,000

The net present value (NPV) of the project can then be calculated as follows:

PV of Year 0 cash flow = -$500,000

PV of Year 1 cash flow = $70,000(0.833 PV lump sum i=20, n=1)

PV of Year 2 cash flow = $70,000(0.694 PV lump sum i=20, n=2)

PV of Year 3 cash flow = $280,000(0.579 PV lump sum i=20, n=3)

PV of Year 4 cash flow = $280,000(0.482 PV lump sum i=20, n=4)

PV of Year 5 cash flow = $280,000(0.402 PV i=20, n=5)

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Section E: Investment Decisions

The sum of these cash flows, which is also the net present value of the project, is $16,530.

Topic: Discounted Cash Flow Analysis

The internal rate of return (IRR) is the discount rate at which the net present value (NPV) is equal to

zero.

The net present value (NPV) of the cash flows for this project at 12% are calculated as follows:

Year 0 (now) cash flows = -$20,000

Year 1 cash flows = $6,000(0.893 PV lump sum i=12, n=1) = $5,358

Year 2 cash flows = $6,000(0.797 PV lump sum i=12, n=2) = $4,782

Year 3 cash flows = $8,000(0.712 PV lump sum i=12, n=3) = $5,696

Year 4 cash flows = $8,000(0.636 PV lump sum i=12, n=4) = $5,088

The sum of these cash flows = $924.

Because these discounted cash flows are greater than 0, that means that the IRR must be somewhat

greater than 12%.

The NPV of the cash flows for this project at 14% are calculated as follows:

Year 0 (now) cash flows = -$20,000

Year 1 cash flows = $6,000(0.877 PV lump sum i=14, n=1) = $5,262

Year 2 cash flows = $6,000(0.769 PV lump sum i=14, n=2) = $4,614

Year 3 cash flows = $8,000(0.675 PV lump sum i=14, n=3) = $5,400

Year 4 cash flows = $8,000(0.592 PV lump sum i=14, n=4) = $4,736

The sum of these cash flows = $12, which is very close to 0, so the IRR is approximately 14%.

Topic: Discounted Cash Flow Analysis

Feedback: The correct answer is: keep operating since the incremental net present value is

approximately $350,000.

The net present value (NPV) of shutting down the plant is calculated as follows:

NPV of shutting down plant = (cash flow from sale of plant) – (cash flow related to severance pay) –

(contract default fee)

Annual cash flow from operating = (revenue) – (variable costs) – (fixed costs)

Revenue = (150,000 units)($100) = $15,000,000

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Section E: Investment Decisions

Variable costs = (150,000)($75) = $11,250,000

Annual cash flow from operating = $(250,000)

NPV of operating cash flows = -$901,250, which is $348,750 (or approximately $350,000) less than

shutting down.

Topic: Discounted Cash Flow Analysis

Feedback: The correct answer is: Accept Project X, and reject Project Y.

Since the projects are mutually exclusive, only one can be accepted. The one with the higher net

present value (NPV) is the one that will be accepted.

NPV for Project X = -$150,000 + $178.177 = $28,177

NPV for Project Y = -$150,000 + $173,880 = $23,880

The NPV of Project X is greater than the NPV of Project Y. Therefore Project X should be accepted

and Project Y rejected.

Topic: Discounted Cash Flow Analysis

Feedback: The correct answer is: the project has an internal rate of return (IRR) less

than 14% since IRR is the interest rate at which net present value is equal to zero.

The internal rate of return (IRR) is the discount rate at which the net present value (NPV) is equal to

zero. Since the NPV at 14% is less than 0, then the IRR is also less than 14%.

Topic: Discounted Cash Flow Analysis

Feedback: The correct answer is: Accept Project A because at a 10% discount rate it has an NPV

that is greater than that of Project B.

The goal of the firm is to maximize owners’ wealth. In order to do this, Stennet will want to maximize

the present value of future cash flows using the net present value (NPV) method to evaluate capital

projects.

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Section E: Investment Decisions

The internal rate of return (IRR) is the discount rate at which the net present value (NPV) is equal to

zero. Since IRR assumes reinvestment at the internal rate of return, rather than at the discount rate

used to compute NPV, it is not a conceptually sound method for making investment decisions.

Therefore, Project A should be accepted, because its NPV is greater than that of Project B.

Topic: Payback and Discounted Payback

Since the project’s internal rate of return (IRR) of 20% exceeds the hurdle rate of 16%, it should be

accepted on that basis.

The project’s payback = $200,000 / $74,000 = 2.7 years, which is less than the minimum 3 years

required. Therefore, the project should be accepted based upon payback.

Topic: Payback and Discounted Payback

The payback is the length of time it takes to recover the initial investment.

After-tax cash flow for year 1 = $60,000(0.6) = $36,000

After-tax cash flow for year 2 = $60,000(0.6) = $36,000

After-tax cash flow for year 3 = $60,000(0.6) = $36,000

After-tax cash flows for year 4 = $80,000(0.6) = $48,000

After-tax cash flows for year 5 = $80,000(0.6) = $48,000

By the end of year 3, Quint will recover $108,000 ($36,000 + $36,000 + $36,000) of the $140,000.

By the end of year 4, Quint will recover $156,000 ($36,000 + $36,000 + $36,000 + $48,000) of the

$140,000.

Therefore, the payback occurs at some point between year 3 and year 4.

The payback can be calculated as follows:

Payback = 3 years + [($140,000 - $108,000) / ($156,000 – $108,000)

Payback = 3 years + ($32 / $48) = 3 years + 0.67 years = 3.67 years, which is approximately 3.7 years.

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Section E: Investment Decisions

Topic: Payback and Discounted Payback

The payback is the length of time it takes to recover the initial investment. The payback period is the

amount of time it takes to have the initial investment equal to the future cash flows.

The investment will recover the initial investment of $20,000 in 3 years, as follows:

Initial investment = -$20,000

Sum of cash flows, years 1, 2 and 3 = $6,000 + $6,000 + $8, 000 = $20,000

At the end of year 3, the cash flows are equal to the initial investment.

Topic: Payback and Discounted Payback

The payback is the length of time that it takes to recover the initial investment.

Cash flow each year = (operating income)(1 – tax rate) + (annual depreciation expense)

Depreciation expense = $400,000 / 5 years = $80,000 per year

Cash flow each year = (operating income)(1 – 0.4) + ($80,000)

years + 0.14 years = 2.14 years.

Topic: Payback and Discounted Payback

The payback is the length of time that it takes to recover the initial investment or, in this case, the

investments.

The cumulative cash flow after 4 years is calculated as follows:

Cumulative cash flow after 4 years = (-$550,000 -$500,000 + $450,000 + $350,000 + $250,000) = 0

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Section E: Investment Decisions

Because the cash outflows are recovered by the fourth year, the payback is therefore four years.

Topic: Ranking Investment Projects

The project’s net present value is negative. Therefore, it should be rejected on that basis. The

project’s payback is $200,000 / $65,000 = 3.08 years which is greater than the 3 year criteria set by

Hobart Corporation. Therefore, the project should be rejected on the payback basis as well.

Topic: Ranking Investment Projects

Since the four projects are mutually exclusive, only one should be accepted. The one that is accepted

will be the one that has the highest net present value (NPV).

NPV = Present Value – Investment

NPV for Option X = $3,800,000 – $3,950,000 = $(150,000)

NPV for Option Y = $3,750,000 – $3,000,000 = $750,000

NPV for Option W = $1,100,000 – $800,000 = $300,000

Topic: Ranking Investment Projects

Feedback: The correct answer is: Project B because it has the highest net present value

(NPV).

The goal of the firm is to maximize owners’ wealth. In order to do this, Wearwell will want to

maximize the present value of future cash flows using the net present value (NPV) method to evaluate

capital projects.

The internal rate of return (IRR) is the discount rate at which the net present value (NPV) is equal to

zero. Since IRR assumes reinvestment at the internal rate of return, rather than at the discount rate

used to compute NPV, it is not a conceptually sound method for making investment decisions.

Since the projects are mutually exclusive, only one can be accepted. That one would be Project B,

which is the one with the highest NPV.

Topic: Ranking Investment Projects

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Section E: Investment Decisions

The goal of the firm is to maximize owners’ wealth. In order to do this, Zinx will want to maximize

the present value of future cash flows using the net present value (NPV) method to evaluate capital

projects.

Zinx should select the combination of projects which produce the highest NPV.

The combination of I, IV, and V has an NPV of $1,128,000, which is calculated as follows:

NPV of I, IV and V = (NPV of I) + (NPV of IV) + (NPV of V)

NPV of I, IV and V = ($3,360,000 – $2,800,000) + ($1,368,000 – $1,200,000) + ($1,000,000 –

4800,000) = $1,128,000

Using a similar approach, the combination of II, III, and IV has an NPV of $1,050,000, and the

combination of II, III, and V has an NPV of $837,000. Similarly, the combination of I and II has an

NPV of $730,000.

Topic: Ranking Investment Projects

The projects should be ranked according to their profitability index (PI).

Project III would rank first, because it has the highest profitability index. Upon choosing Project III,

$650,000 of the $1,500,000 in available funds would be used.

Project IV would come second and use up another $750,000, bringing the total used to $1,400,000

($650,000 + $750,000), leaving only $100,000 for further investment. The investment amounts for the

remaining two projects exceed $100,000, so no further projects can be selected.

Topic: Ranking Investment Projects

The NPV of the original project is calculated as follows:

NPV, original project = -$2,500,000 + $800,000(3.605 PV annuity i=12, n=5)

NPV, original project = $384,000

NPV, Scenario R = -$2,500,000 + $2,595,600 = $95,600, which has the least effect on NPV of the

three scenarios.

NPV, Scenario S = $2,500,000 - $2,501,600 = $1,600. The effect is greater than that of scenario R,

but less than that of scenario T.

NPV, Scenario T = -$70,400, which has the greatest effect on NPV of the three scenarios.

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Section E: Investment Decisions

Topic: Risk Analysis in Capital Investments

To calculate the expected net present value (NPV) of the project, the first step is to calculate the

expected annual sales, as follows:

Expected annual sales volume= (80,000)(0.1) + (85,000)(0.2) + (90,000)(0.3) + (95,000)(0.2) +

(100,000)(0.1) + (110,000)(0.1)

Expected annual sales volume = 8,000 + 17,000 + 27,000 + 19,000 + 10,000 + 11,000

Expected annual sales volume= 92,000

The expected margin per year, would then be calculated as follows:

Expected annual margin = (92,000)($5) = $460,000

The cash flow for each of the five years of the project is calculated as follows:

Cash flow, each year = (contribution margin – depreciation)(1 – tax rate) + depreciation

Depreciation = $1,000,000 / 5 years = $200,000 per year

Cash flow, each year = ($460,000 – $200,000)(1 – 0.4 + $200,000

Cash flow, each year = $260,000(0.6) + $200,000 = $156,000 + $200,000 = $356,000

The expected net present value (NPV) of the project can now be calculated:

Expected NPV of project = (initial investment) + (estimated annual cash flow)(PV factor of annuity,

i=12, n=5)

Expected NPV of project = -$1,000,000 + ($356,000)(3.605) = $283,380

Topic: Risk Analysis in Capital Investments

The expected annual cash flow for Project R is the $95,000 mid-point of the symmetrical probability

distribution. To solve this problem, first take the ratio of the range of the cash flows to the expected

value, as follows:

The ratio of the range of the cash flows to the expected value for Project R is:

($115,000 – $75,000) / $95,000 = $40,000 / $95,000 = 42%

The expected annual cash flow for Project S is the $110,000 mid-point of the symmetrical probability

distribution.

The ratio of the range of the cash flows to the expected value for Project S is:

($150,000 – $70,000) / $110,000 = $80,000 / $110,000 = 73%

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Section E: Investment Decisions

The ratio for Project S is higher than the ratio for Project R. Therefore, Project S is the riskier project

requiring the higher discount rate.

NPV, Project S = -$500,000 + $110,000(4.833 PV annuity i=16, n=10)

NPV, Project S = -$500,000 + $531,630 = $31,630

NPV, Project R = -$500,000 + $95,000(5.65 PV annuity i=12, n=10)

NPV, Project R = -$500,000 + $536,750 = $36,750

Topic: Risk Analysis in Capital Investments

The expected annual after-tax cash flow from the project is calculated as follows:

Expected annual after-tax cash flow = ($45,000)(0.1) + ($50,000)(0.2) + ($55,000)(0.3) +

($60,000)(0.2) + ($65,000)(0.1) + ($70,000)(0.1)

Expected annual after-tax cash flow = $4,500 + $10,000 + $16,500 + $12,000 + $6,500 + $7,000

Expected annual after-tax cash flow = $56,500

The annual after-tax cash flow required to generate a positive net present value (NPV) would be found

by setting the NPV at 14% to 0.

The equation would be set up as follows:

(cash flow)(3.433 PV annuity i=14, n=5) – $200,000 = 0

3.433(cash flow) = $200,000

cash flow = $58,258, which is almost $60,000.

The probability of having annual cash flows of $60,000 = 40% = (20% @ $60,000 + 10% @ $65,000

+ 10% @ $70,000)

- END -