CB3410 Final Exam Practical Questions PDF

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Part I: Multiple Choice Questions (20 Questions worth 40 points in total, 2 points each) Anthony and Ian are in the process of setting up their own company. They are considering making it either as a partnership or as a corporation. Eventually they decide to set up the company as a separate legal en...

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Part I: Multiple Choice Questions (20 Questions worth 40 points in total, 2 points each) 1.

Anthony and Ian are in the process of setting up their own company. They are considering making it either as a partnership or as a corporation. Eventually they decide to set up the company as a separate legal entity, meaning that they have no personal liability for the firm’s debt. They will share ownership of that firm on a 50-50 basis. Which of the following statements are correct descriptions of their business?

i.

The form of their company is partnership.

ii.

If their firm is located in the United States, Anthony and Ian should be concerned of the double-taxation problem, which means both the interest expense and the dividends are taxed by the government.

iii.

In the event of bankruptcy, Anthony and Ian may lose all their investment since they are last in line to get back their stakes.

(A)

i, ii, and iii

(B)

i and iii

(C)

ii and iii

(D)

iii only

2.

Which one of the following defines the internal rate of return for a project?

(A)

Discount rate that creates a zero cash flow from assets

(B)

Discount rate that results in a zero net present value for the project

(C)

Discount rate that results in a net present value equal to the project's initial cost

(D)

Rate of return required by the project's investors

(E)

The project's current market rate of return

3.

Which of the following statement(s) about the Market Efficiency Hypothesis is (are) correct?

i.If investors can consistently beat the market by studying publicly available financial reports, the market is semi-strong form efficient. ii.If a market is strong form efficient, it must be semi-strong form efficient. iii.A market has strong form efficiency if it reflects information more quickly than a semi-strong form market. (A)

ii only

(B)

iii only

(C)

i and iii

(D)

ii and iii

4.

Which one of the following is the slope of the security market line?

(A)

Risk-free rate

(B)

Market risk premium

(C)

Beta coefficient

(D)

Risk premium on an individual asset

(E)

Market rate of return

5.

Which of the following is true about the WACC?

(A)

When computing the weights for different source of capital, the book values are preferable to the market values.

(B)

Cost of debt is the ratio of interest expense in the income statement to the total amount of debt outstanding.

(C)

The effect of taxes increases the cost of debt and makes debt financing less attractive for corporations.

(D)

The cost of equity reflects the riskiness of the project.

6.

Which statement about portfolio diversification is correct?

(A)

Proper diversification can eliminate systematic risk.

(B)

The risk-reducing benefits of diversification do not occur until at least 50-60

individual securities have been purchased. (C)

Because diversification reduces a portfolio's total risk, it necessarily reduces

the portfolio's expected return.

(D)

Typically, as more securities are added to a portfolio, total risk would be ex-

pected to decrease at a decreasing rate (E)

Proper diversification can eliminate both systematic and unsystematic risk.

7.

If the CAPM holds true, which of the following asset has the highest systematic risk?

(A)

Asset A

(B)

Asset B

(C)

Asset C

(D)

Asset D

(E)

Cannot be determined

If the CAPM holds true, E(r)=rf+β(rm- rf), and β measures the systematic risk. Given rf and (rm- rf), the expected return increases with the value of β. Thus, Asset A has the highest expected return and the highest systematic risk (β).

8.

An investment has conventional cash flows (i.e., project cash flows occur at the beginning of each period) and a profitability index of 1.0. Given this, which one of the following must be true?

(A)

The internal rate of return exceeds the required rate of return.

(B)

The net present value is equal to zero.

(C)

The average accounting return is 1.0.

(D)

The net present value is greater than 1.0.

(E)

None of the above.

9.

An investment has conventional cash flows (i.e., project cash flows occur at the beginning of each period) and a profitability index of 1.0. Given this, which one of the following must be true?

(A)

The internal rate of return exceeds the required rate of return.

(B)

The net present value is equal to zero.

(C)

The average accounting return is 1.0.

(D)

The net present value is greater than 1.0.

(E)

None of the above.

10.

Chandler Tire Co. is trying to decide which one of two projects it should accept. Both projects have the same start-up costs. Project 1 will produce annual cash flows of $52,000 a year for six years. Project 2 will produce cash flows of $48,000 a year for eight years. The company requires a 15 percent rate of return. Which project should the company select and why?

(A)

Project 1, because the annual cash flows are greater than those of Project 2

(B)

Project 1, because the present value of its cash inflows exceeds those of Project 2 by $14,211.62

(C)

Project 2, because the total cash inflows are $70000 greater than those of Project 1

(D)

Project 2, because the present value of the cash inflows exceeds those of Project 1 by $18,598.33

(E)

It does not matter as both projects have almost identical present values.

11.

The rate of return on which one of the following is used as the risk-free rate?

(A)

Long-term government bonds

(B)

Long-term corporate bonds

(C)

Inflation, as measured by the Consumer Price Index

(D)

U.S. Treasury bill

(E)

Large-company stocks

Use following information for Questions 12 and 13: XYZ Co. is a conglomerate with two divisions. One division sells consumer electronics, has total assets of $20 million, and can generate annual earnings of $3million. The other division sells frozen food, has assets of $5 million, and can generate annual

earnings of $1 million. XYZ Co. has a total of 5 million common shares outstanding and has a total debt ratio of 0. The following table summarizes financial information on other firms. Total Debt

Stock

Firm

Business

Beta

Ratio

Price

EPS

E

Consumer Electronics

1.2

0.2

$164.40

$12.00

F

Technology

1.5

0.15

$112.00

$7.00

G

Frozen Food

0.9

0.45

$44.00

$4.00

H

Conglomerate

0.8

0.38

$100.00

$8.00

I

Utility

0.6

0.75

$120.00

$5.00

12.

Use the method of multiples to estimate XYZ’s stock price.

(A)

$9.88

(B)

$10.00

(C)

$10.42

(D)

$12.35

Total Debt

Stock

P/E

Firm

Business

Beta

Ratio

Price

EPS

Ratio

E

Consumer Electronics

1.2

0.2

$164.40

$12.00

13.7

G

Frozen Food

0.9

0.45

$44.00

$4.00

11

XYZ’s stock price=(13.7*3,000,000+11*1,000,000)/5,000,000=$10.42

13.

Which of the following is most likely to be the beta of XYZ’s stock?

(A)

0.74

(B)

0.80

(C)

1.12

(D)

1.28

14.

Design Interiors has a cost of equity of 18.6 percent and a pretax cost of debt of 9.7 percent. The firm's target weighted average cost of capital is 12 percent and its tax rate is 35 percent. What is the firm's target debt-equity ratio?

(A)

0.81

(B)

0.87

(C)

0.98

(D)

1.02

(E)

1.16

WACC=RE*E/(D+E)+ RD*D/(D+E)*(1-t)=18.6%*E/(D+E)+ 9.7%*D/(D+E)*(135%)=12% D/E=1.16 15.

A firm has net income of $6,850 and interest expense of $2,130. The tax rate is 34 percent. What is the firm's times interest earned ratio?

(A)

5.19

(B)

5.38

(C)

5.87

(D)

6.33

(E)

7.35

EBIT=6850/(1-34%)+2130=12508.79 Times interest earned ratio=EBIT/Interest=12508.79/2130=5.87 16.

You are considering taking out a $200,000 mortgage to buy a house. Your bank will charge you a 6% APR (compounded monthly) on a 30 year mortgage with monthly payments. Your first payment is due in one month. Calculate the monthly payment for this mortgage.

(A)

$199.10

(B)

$555.56

(C)

$1,199.10

(D)

$12,335.60

r=6%/12=0.5% $200,000=C/0.5%*[1-1/(1+0.5%)^360] C=$1,199.10

17.

Toyota stock has the following probability distribution of expected prices one year from now:

If you buy Toyota today for $55 and it will pay a dividend during the year of $4 per share, what is your expected return on Toyota by holding the stock for one year (use the expected price)? (A)

16.21%

(B)

17.72%

(C)

18.89%

(D)

17.91%

(E)

18.18%

E(P)=25%*50+40%*60+35%*70=$61 r=(E(P)-P+D)/P=($61-$55+$4)/$55=18.18%

Part II: Long Questions Note: Please show all relevant steps in deriving the final answers. LQ1.

XYZ Co. is considering two mutually exclusive advertisement campaigns. The incremental free cash flows of the two projects are as follow: Year 0

Year 1

Year 2

Year 3

Year 4

Project A

-450

380

380

380

-700

Project B

-700

300

300

350

100

(A) Provide two reasons on why XYZ Co. should not apply the IRR rule to make capital budgeting decisions. (10 points)

Ans: 1. The cash flows of Project A change sign more than once. This may result in multiple IRRs. 2. The two projects have different initial investment amount. The NPV profiles of these two projects may cross each other. 3. The IRR rule should not be used when comparing two mutually exclusive projects since IRRs do not provide information on the dollar amount of value added of the two projects. (B) Suppose a required rate of 10% is required on your investment. Based on NPV criterion, which project will you choose? (10 points, show calculation as well)

ANS: The NPV for each project is: A: NPV = – 450 + 380/1.1 + 380/1.1**2 + 380/1.1**3 - 700/1.1**4 = 16.89

B: NPV = – 700 + 300/1.1 + 300/1.1**2 + 350/1.1**3 + 100/1.1**4 = 151.92 NPV criterion implies we accept project B because project B has a higher NPV than project A.

LQ2. You are considering an investment project that will last for 3 years. Project details are as follows:

• The project will generate revenues of $160,000 and expenses of $105,000 each year. • The project will require initial investment of a new equipment valued at $65,000. This equipment will be depreciated to $5,000 using the straight-line method over a three-year life. You will sell the equipment for $3,000 when the project ends. • The firm’s net working capital will have to rise to $20,000 from the current level of $10,000 immediately. It will remain the same in year 1, go down to $15,000 in year 2, and then return to its original level of $10,000 in year 3. • You will transfer one manager already working for you to the project. Her annual salary is $30,000. Even if you do not undertake this project, you would still hire her for other projects. • You also plan to hire a new manager at the same salary ($30,000 per year) if you undertake this project. • Your marginal tax rate is 30%.

(A) Tabulate revenue, all costs including depreciation and then compute EBIT, tax, and net income for years 0, 1, 2, and 3; (8 points) (B) Compute the cashflow from assets (also known as free cash flow) for years 0, 1, 2, and 3; (8 points) (C) Decide whether or not to accept the project by computing NPV based on a discount rate of 10%. (4 points)

Ans:

Year 0

Year 1

Year 2

Year 3

Revenue

160,000 160,000 160,000

Expense

105,000 105,000 105,000

Depreciation

20,000

20,000

20,000

Salary

30,000

30,000

30,000

EBIT

5,000

5,000

5,000

Taxes

1,500

1,500

1,500

20,000

20,000

20,000

0

-5,000

-5,000

Depreciation ΔNWC

10,000

CapEx

65,000

Sale of Equip3,600

ment

FCF

-75,000

23,500

28,500

32,100

Depreciation expense = (65,000 – 5,000) / 3 = 2,000 Sale of equipment = 3,000 – 0.3* (3,000 – 5,000) = 3,600

𝑵𝑷𝑽 = −𝟕𝟓, 𝟎𝟎𝟎 +

$𝟐𝟑, 𝟓𝟎𝟎 $𝟐𝟖, 𝟓𝟎𝟎 $𝟑𝟐, 𝟏𝟎𝟎 = −𝟓, 𝟗𝟔𝟓 + + 𝟏. 𝟏𝟑 𝟏. 𝟏 𝟏. 𝟏𝟐

Reject the project since its NPV is negative...