FUNDAMENTALS OF CORPORATE FINANCE

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1 FUNDAMENTALS OF CORPORATE FINANCE Time Allowed: 2 Hours30 minutes Reading Time:10 Minutes GBAT9123 Sample exam SUPERVISED OPEN BOOK EXAMINATION INSTRUCTIONS 1. This is a supervised open book examination. The textbook, Ross et al, Essentials of Corporate Finance, the Study Guide, personal notes, pens, pencils and erasers are permitted to be brought into the examination room 2. You are allowed to use electronic devices for the purpose of referring to digital course materials and notes only. These devices must not be connected to the internet, Wi-Fi must be disabled and tablets must be in flight mode. They must not be used to type your exam responses. You may use a scientific/financial calculator or a spreadsheet/calculator installed in the devices for the purpose of performing calculations. 3. Your reading time before the examination is 10 minutes. During reading time, only the examination paper may be read. Candidates are not permitted to write during reading time except to write your name and student number below and on the Generalised Answer Sheet to be used for Section A. 4. This examination consists of two sections: Section A TWENTY FIVE (25) Multiple Choice Questions. (60 marks) Attempt all questions in Section A. These questions are of equal value. There are no negative marks. Answers to Section A must be indicated in pencil on the Generalised Answer Sheet provided. Section B THREE (3) Short Essay Questions. (40 marks) Answer any two (2) questions in Section B. The questions are of equal value and you should give equal effort to both of the questions in this section. Answers must be written in blue or black ink on the nine (9) ruled pages provided at the end of the questions. Do not write answers for this section in an exam booklet. Start the answer to each question on a new page. Formulae and NPV tables are provided at the end of this examination paper. 5. This exam paper must be returned with your answer books at the conclusion of the examination. No documentation is to be retained by candidates. 6. The exam contributes 50% towards your final grading in this course. Please complete the following details: Student ID: Family Name: Other Name: GBAT9123_FCFN_Exam Page 1 of 25

2 SECTION A 25 MULTIPLE CHOICE QUESTIONS Taking rounding into account, choose the option that best approximates the correct answer. Q1. When you retire 40 years from now, you want to have $1.2 million. You think you can earn an average of 12% on your investments. To meet your goal, you are trying to decide whether to deposit a lump sum today, or to wait and deposit a lump sum 2 years from today. How much more will you have to deposit as a lump sum if you wait for 2 years before making the deposit? A. $1, B. $2, C. $2, D. $3, E. $3, Q2. Sixteen years ago, Alicia invested $1,000. Eight years ago, Travis invested $2,000. Today, both Alicia s and Travis investments are each worth $2,400. Assume that both Alicia and Travis continue to earn their respective rates of return. Which one of the following statements is correct concerning these investments? A. Three years from today, Travis investment will be worth more than Alicia s. B. One year ago, Alicia s investment was worth less than Travis investment. C. Travis earns a higher rate of return than Alicia. D. Travis has earned an average annual interest rate of 3.37%. E. Alicia has earned an average annual interest rate of 6.01%. Q3. Dexter Mills issued 20-year bonds a year ago at a coupon rate of 11.4%. The bonds make semi-annual payments. The yield-to-maturity on these bonds is 9.2%. The face value of the bond is $1,000. What is the current bond price? A. $ B. $ C. $1, D. $1, E. $1, GBAT9123_FCFN_Exam Page 2 of 25

3 Q4. Bryceton, Inc. has bonds on the market with 13 years to maturity, a yield-tomaturity of 9.2%t, and a current price of $ The bonds make semiannual payments. The face value of the bond is $1,000. What is the coupon rate? A. 7.80% B. 8.00% C. 8.25% D. 8.40% E. 8.65% Q5. The Square Box is considering two projects, both of which have an initial cost of $35,000 and total cash inflows of $50,000. The cash inflows of project A are $5,000, $10,000, $15,000, and $20,000 over the next four years, respectively. The cash inflows for project B are $20,000, $15,000, $10,000, and $5,000 over the next four years, respectively. Which one of the following statements is correct if The Square Box requires a 12% rate of return and has a required discounted payback period of 3.5 years? A. Both projects should be accepted. B. Both projects should be rejected. C. Project A should be accepted and project B should be rejected. D. Project A should be rejected and project B should be accepted. E. You should be indifferent to accepting either or both projects. Q6. Consider an asset that costs $176,000 and is depreciated straight-line to zero over its 11-year tax life. The asset is to be used in a 7-year project; at the end of the project, the asset can be sold for $22,000. The relevant tax rate is 30%. What is the after-tax cash flow from the sale of this asset? A. $31,800 B. $32,600 C. $33,300 D. $34,100 E. $34,600 Q7. Phone Home, Inc. is considering a new 5-year expansion project that requires an initial fixed asset investment of $2.484 million. The fixed asset will be depreciated straight-line to zero over its 5-year tax life, after which time it will be worthless. The project is estimated to generate $2,208,000 in annual sales, with costs of $883,200. The tax rate is 32% and the required return on the project is 11%. What is the net present value for this project? A. $1,432,155 B. $1,433,059 C. $1,434,098 D. $1,434,217 E. $1,435,008 GBAT9123_FCFN_Exam Page 3 of 25

4 Q8. A 4-year project has an initial asset investment of $306,600, and initial net working capital investment of $29,200, and an annual operating cash flow of -$46,720. The fixed asset is fully depreciated over the life of the project and has no salvage value. The net working capital will be recovered when the project ends. The required return is 15%. What is the project s equivalent annual cost, or EAC? A. -$158,491 B. -$152,309 C. -$147,884 D. -$145,509 E. -$142,212 Q9. The standard deviation of a portfolio: A. is a weighted average of the standard deviations of the individual securities held in the portfolio. B. can never be less than the standard deviation of the most risky security in the portfolio. C. must be equal to or greater than the lowest standard deviation of any single security held in the portfolio. D. is an arithmetic average of the standard deviations of the individual securities which comprise the portfolio. E. can be less than the standard deviation of the least risky security in the portfolio. Q10. Which one of the following statements related to unexpected returns is correct? A. All announcements by a firm affect that firm s unexpected returns. B. Unexpected returns over time have a negative effect on the total return of a firm. C. Unexpected returns are relatively predictable in the short-term. D. Unexpected returns generally cause the actual return to vary significantly from the expected return over the long-term. E. Unexpected returns can be either positive or negative in the short term but tend to be zero over the long-term. GBAT9123_FCFN_Exam Page 4 of 25

5 Q11. What is the expected return on this portfolio? A % B % C % D % E % Q12. The common stock of Alpha Manufacturers has a beta of 1.47 and an actual expected return of 15.26%. The risk-free rate of return is 4.3% and the market rate of return is 12.01%. Which one of the following statements is true given this information? A. The actual expected stock return will graph above the Security Market Line. B. The stock is underpriced. C. To be correctly priced according to CAPM, the stock should have an expected return of 21.95%. D. The stock has less systematic risk than the overall market. E. The actual expected stock return indicates the stock is currently overpriced. Q13. Which one of the following stocks is correctly priced if the risk-free rate of return is 3.2% and the market rate of return is 11.76%? Stock Beta Expected Return A % B % C % D % E % A. A B. B C. C D. D E. E GBAT9123_FCFN_Exam Page 5 of 25

6 Q14. The after-tax cost of debt: A. varies inversely to changes in market interest rates. B. will generally exceed the cost of equity if the relevant tax rate is zero. C. will generally equal the cost of preferred if the tax rate is zero. D. is unaffected by changes in the market rate of interest. E. has a greater effect on a firm s weighted average cost of capital when the debt-equity ratio increases. Q15. Which one of the following statements is correct for a firm that uses debt in its capital structure? A. The WACC (weighted average cost of capital) should decrease as the firm s debt-equity ratio increases. B. When computing the WACC, the weight assigned to the preferred stock is based on the coupon rate multiplied by the par value of the preferred. C. The firm s WACC will decrease as the corporate tax rate decreases. D. The weight of the common stock used in the computation of the WACC is based on the number of shares outstanding multiplied by the book value per share. E. The WACC will remain constant unless a firm retires some of its debt. Q16. Sister Pools sells outdoor swimming pools and currently has an after-tax cost of capital of 11.6%. Al s Construction builds and sells water features and fountains and has an after-tax cost of capital of 10.8%. Sister Pools is considering building and selling its own water features and fountains. The sales manager of Sister Pools estimates that the water features and fountains would produce 20% of the firm s future total sales. The initial cash outlay for this project would be $85,000. The expected net cash inflows are $16,000 a year for 7 years. What is the net present value of the Sister Pools project? A. -$11,044 B. -$9,115 C. -$7,262 D. -$4,508 E. $1,219 GBAT9123_FCFN_Exam Page 6 of 25

7 Q17. Jenningston Mills has a market value equal to its book value. Currently, the firm has excess cash of $1,200, other assets of $5,800, and equity valued at $3,750. The firm has 250 shares of stock outstanding and net income of $420. What will the new earnings per share be if the firm uses 25% of its excess cash to complete a stock repurchase (share buy-back)? A. $1.83 B. $1.89 C. $1.96 D. $2.00 E. $2.08 Q18. ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $480,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $240,000 and the interest rate on its debt is 11%. Both firms expect EBIT (earnings before interest and tax) to be $58,400. Ignore taxes. The cost of equity for ABC is %, and for XYZ it is %. A ; B ; C ; D ; E ; Q19. New Schools, Inc. expects an EBIT (earnings before interest and tax) of $7,000 every year forever. The firm currently has no debt, and its cost of equity is 17%. The firm can borrow at 8% and the corporate tax rate is 34%. What will the value of the firm be if it converts to 50% debt? (Note when levered, the value of debt is equal to one- half of the value of the un-levered value of the firm) A. $29, B. $31, C. $32, D. $34, E. $37, Q20. Prospect Engineering Corp is making a rights offering. There are 2,000,000 shares outstanding at $15 each (market price). The company proposes to issue 400,000 new shares at $13 each. What is the value of one right? A. $0.33 B. $1.67 C. $2.67 D. $1.89 E. $2.12 GBAT9123_FCFN_Exam Page 7 of 25

8 Q21. Randwick Daily News needs to raise $40 million by means of a rights offer. It has 4.1 million shares outstanding at $53 (market price). The subscription price is set at $48. What is the value of one right? A. $4.16 B. $1.64 C. $0.84 D. $1.98 E. $2.54 Q22. You currently own 8% of the 3.5 million outstanding shares of Webster Mills. The company has just announced a rights offering with a subscription price of $28. One right will be issued for each share of outstanding stock. This offering will provided $9 million of new financing for the firm, ignoring all issue costs. Assume that all rights are exercised. What will be your new ownership position if you opted to sell your rights rather than exercise them personally? A. 7.33% B. 7.46% C. 7.87% D. 8.00% E. 8.21% Q23. Underwater Experimental is considering a project which requires the purchase of $498,000 of fixed assets. The net present value of the project is $22,500. Equity shares will be issued as the sole means of financing the project. What will the new book value per share be after the project is implemented given the following current information on the firm? Number of shares outstanding 60,000 Book value $720,000 Market value $936,000 Net income $108,000 A. $13.25 B. $13.70 C. $14.23 D. $14.94 E. $15.60 GBAT9123_FCFN_Exam Page 8 of 25

9 Q24. Which one of the five factors included in the Black-Scholes model cannot be directly observed? A. risk-free rate B. strike price C. standard deviation D. stock price E. life of the option Q25. What is the price of a put option given the following information? Stock Price $81 Exercise (Strike) price $88 Risk free rate Maturity Standard deviation A. $16.57 B. $16.83 C. $17.74 D. $18.47 E. $ months 64% per year 4% per year, compounded continuously GBAT9123_FCFN_Exam Page 9 of 25

10 SECTION B ANSWER ANY TWO (2) QUESTIONS (40 marks in total for Section B) You may use an exam booklet for planning an outline for your answers, but your answers must be written on this examination paper on the ruled pages that follow. QUESTION 1 (20 marks) From the perspective of the company s objective of improving market value for its stake-holders opinion on dividend and debt policies seems divided. Why? How are they related? Discuss these issues and illustrate your answer by current topical examples. QUESTION 2 (20 marks) In the current market conditions discuss issues that are relevant to an IPO (initial public offering) issue. Illustrate with current/recent examples. QUESTION 3 (20 marks) Enumerate some roles that derivatives play in corporate financial decisions. How did they (derivatives) contribute to the onset of the Global Financial Crisis? GBAT9123_FCFN_Exam Page 10 of 25

11 Write your TWO (2) answers from Section B on the following pages. GBAT9123_FCFN_Exam Page 11 of 25

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20 FORMULAE FOR EXAM GBAT9123 FUNDAMENTALS OF CORPORATE FINANCE R E = R A +( R A - R D ) D/E Variance (X)= n i=1 ( xi - X 2 ) Pi E( Ri )= R f + [E( RM ) - R f ] β i ρ im. σ i. σ M = Cov( Ri,R M ) Var( RP )= w1 σ 1 + w2 σ ρw w σ 1σ 2 t PV ordinary annuity = [1 1/(1 + r) ]/ r FV ordinary annuity = [(1 + r) R E = R V Future value = (1 + r) U PV = (1 + r) E( R + ( R E L =V p U +T R )( D / E)(1 T ) A U ) = n i= 1 D C D1 P0 = r g D t E( R ) β = β (1 + D / E) i t 1 t 2 1]/ r C V u = EBIT(1-T c)/r u Co variance( R, ) ( ) i R Beta i = M σ 2 M GBAT9123_FCFN_Exam Page 20 of 25

21 Effective annual rate = [ 1 + (nominal rate)/m ] m - 1 (1 + R) = (1 + r) (1 + h) Value of right(s) = n(m-s)/(n+r) Put call parity S+P=PV(E)+C Put call parity in continuous time: S+P=Ee -Rt +C Black-Scholes c= SNd ( ) Ee Nd ( ) d 1 = 2 1 Rt * 1 2 S E R t 2 ln( / ) + ( + σ / 2) d = d σ t σ t GBAT9123_FCFN_Exam Page 21 of 25

22 Future value interest factor of $1 per period at i% for n periods, FVIF(i,n). Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% , , , , , , , , MBT FCFN Exam Page 22 of 25

23 Present value interest factor of $1 per period at i% for n periods, PVIF(i,n) Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% MBT FCFN Exam Page 23 of 25

24 Future value interest factor of an ordinary annuity of $1 per period at i% for n periods, FVIFA(i,n). Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% , , , , , , , , , , , , , , , , , , , , ,436 15,090 21,813 31,515 45,497 MBT FCFN Exam Page 24 of 25

25 Present value interest factor of an (ordinary) annuity of $1 per period at i% for n periods, PVIFA(i,n) Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% MBT FCFN Exam Page 25 of 25

Chapter 14 - Cost of Capital. Cost of Capital

Chapter 14 - Cost of Capital. Cost of Capital Cost of Capital 1. A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith, Inc. What is the return that these individuals require on this investment