Exam 1 2017, questions PDF

Preview

Summary

OFFICE USE ONLY Monash University Sample Past Exam 1 Faculty of Business and Economics Department of Accounting and Finance EXAM CODES: AFC2140 TITLE OF PAPER: Corporate Finance EXAM DURATION: 3 hours READING TIME: 10 minutes THIS PAPER IS FOR STUDENTS STUDYING AT: (office use only tick where applic...

Description

OFFICE USE ONLY

Monash University Sample Past Exam 1 Faculty of Business and Economics Department of Accounting and Finance EXAM CODES:

AFC2140

TITLE OF PAPER:

Corporate Finance

EXAM DURATION:

3 hours

READING TIME:

10 minutes

THIS PAPER IS FOR STUDENTS STUDYING AT: (office use only - tick where applicable)  Berwick

 Clayton

 Peninsula

 Distance Education

 Caulfield

 Gippsland

 Sunway

 Open Learning

 Other (specify)

During an exam, you must not have in your possession, a book, notes, paper, calculator, pencil case, mobile phone or any other material/item which has not been authorised for the exam or specifically permitted as noted below. Any material or item on your desk, chair or person will be deemed to be in your possession. You are reminded that possession of unauthorised materials in an exam is a disciplinable offence under Monash Statute 4.1. AUTHORISED MATERIALS CALCULATORS

 YES

 NO

(If YES, only calculators with an 'approved for use' Faculty label are permitted) OPEN BOOK

 YES

 NO

SPECIFICALLY PERMITTED ITEMS if yes, items permitted are:

 YES

 NO

This paper consists of eight (8) questions printed on a total of ten (10) pages. Students must attempt to answer ALL questions.

STUDENT ID: …………………………...

DESK NUMBER: …………………….

PLEASE CHECK THE PAPER BEFORE COMMENCING. THIS IS A FINAL PAPER. THIS EXAMINATION PAPER MUST BE INSERTED INTO THE ANSWER BOOK AT THE COMPLETION OF THE PAPER. NO EXAMINATION PAPERS SHOULD BE REMOVED FROM THE EXAMINATION ROOM

AFC2140

Page 1 of 10

OFFICE USE ONLY

AFC2140 CORPORATE FINANCE

Question 1 (a) Briefly describe three forms of business organisation: a sole trader; a partnership; and companies. (3 marks) (b) Between the bond holder (buyer) and the bond issuer (seller) which party is borrowing money and which party is lending money? (2 marks) (c) Explain why there is an inverse relationship between interest rates (YTM) and bond prices. (4 marks) (d) Should the credit rating of a bond be upgraded, what is the likely effect upon the required rate of return of the bond? Explain why such an effect occurs. (3 marks) (Total = 12 marks) Question 2 You are given the following information relating to four companies. Assume that dividends will be paid in perpetuity and do not grow over time.

Share A Share B Share C Share D

Market Price ($) EPS ($) 500 25 0.2 0.05 30 15 10 4

Dividend per Share ($) 20 0.02 10 2

Discount Rate (%) 5 12 15 8

Required: (a) Rank the shares from cheapest to most expensive based on P/E valuation. Which is the cheapest and which is most expensive share? (6 marks) (b) For each share, use the dividend discount model (DDM) to estimate fair value. On the basis of your estimate, which shares would you recommend to buy or sell? Provide an explanation for each recommendation you make. (6 marks) (Total= 12 marks)

AFC2140

Page 2 of 10

OFFICE USE ONLY

AFC2140 CORPORATE FINANCE

Question 3 (a) What is the capital budgeting process? Why is the capital budgeting decision considered the most important decision made by a company’s management? (3 marks) (b) Why is net present value (NPV) method for capital budgeting decisions considered to be superior to alternative methods? (3 marks) (c) What is the payback period method? What are its advantages? What are its disadvantages? (4 marks)

(d) What is the accounting rate of return (ARR) method? Why is this method not recommended as a capital expenditure decision-making tool? (5 marks) (Total = 15 marks)

AFC2140

Page 3 of 10

OFFICE USE ONLY

AFC2140 CORPORATE FINANCE

Question 4 (a) AOI Ltd. is evaluating two mutually exclusive projects. The company needs to decide between two alternative technologies for producing its line of widgets. Each technology will generate the same revenues from the sale of the widgets, but the expenses incurred in using the different technologies vary resulting in different net cash flows. Technology 1 has a life of 5 years, and technology 2 has a life of 3 years before they need replacing. The firm uses a 13.8 percent discount rate for such projects. Outlays and cash flows are shown in the table below. Using an NPV in perpetuity approach, determine which technology the firm should select? Year 0 1 2 3 4 5

Technology 1 $(7,500,000) $3,200,000 $1,800,000 $1,800,000 $2,200,000 $2,000,000

Technology 2 $(9,200,000) $2,500,000 $5,000,000 $5,000,000

(9 marks)

(b) You have a 1993 Nissan that is expected to run for another three years, but you are considering buying a new Hyundai before the Nissan wears out. You intend to donate the Nissan to a nearby charity when you buy the new car. The annual maintenance cost for the new Hyundai is estimated to be $200 per annum. You estimate that if you were to keep the old Nissan for the next three years, the maintenance costs for the first year would be $1,500, $1,600 for the second, and $1,800 for the final year. The price of your favorite Hyundai model is $18,000 and it is expected to run for 15 years. Your opportunity cost of capital is 3 percent. Ignore tax. When should you buy the new Hyundai?

(6 marks) (Total = 15 marks)

AFC2140

Page 4 of 10

OFFICE USE ONLY

AFC2140 CORPORATE FINANCE

Question 5 (a) John is watching an old game show on rerun television called Let’s Make a Deal in which you have to choose a prize behind one of two curtains. One of the curtains will yield a gag prize worth $150, and the other will give a car worth $7,200. The game show has placed a subliminal message on the curtain containing the gag prize, which makes the probability of choosing the gag prize equal to 75 per cent. What is the expected value of the selection, and what is the standard deviation of that selection? (4 marks) (b) The distribution of grades in an introductory finance class is normally distributed, with an expected grade of 80. If the standard deviation of grades is 8, in what range would you expect 95 per cent of the grades to fall? (Note: Approximately 95% of the population will fall within 1.96 standard deviations from the mean) (3 marks) (c)

Given the returns and probabilities for the three possible states listed here, calculate the covariance between the returns of Share A and Share B. For convenience, assume that the expected returns of Share A and Share B are 9 per cent and 10 per cent, respectively. Probability Return(A) Return(B) Good 0.35 0.20 0.30 OK 0.50 0.10 0.10 Poor 0.15 -0.20 -0.30 (2 marks)

(d) Describe how investing in more than one asset can reduce risk through diversification.

(2 marks) (e) Describe the Capital Asset Pricing Model (CAPM) and what it tells us. (3 marks) (Total = 14 marks)

AFC2140

Page 5 of 10

OFFICE USE ONLY

AFC2140 CORPORATE FINANCE

Question 6 (a) What is the weighted average cost of capital? (2 marks)

(b) Capital Ltd has a capital structure that is financed, based on current market values, with 50 per cent debt, 10 per cent preference shares, and 40 per cent ordinary shares. If the return offered to the investors for each of those sources is 8 per cent, 10 per cent, and 15 per cent for debt, preference shares, and ordinary shares, respectively, then what is Capital’s after-tax WACC? Assume that the company’s corporate tax rate is 30 per cent. (2 marks)

(c)

A company financed totally with ordinary equity is evaluating two distinct projects. The first project has a large amount of non-systematic risk and a small amount of systematic risk. The second project has a small amount of non-systematic risk and a large amount of systematic risk. Which project, if taken, will have a tendency to increase the company’s cost of capital? (2 marks)

(d) You know that the return of Momentum Cyclicals’ ordinary shares reacts to macroeconomic information 1.6 more times than the return of the market. If the risk-free rate of return is 4 per cent and the market risk premium is 6 per cent, what is Momentum Cyclicals’ cost of ordinary equity capital?

(2 marks) (e) In your analysis of the cost of capital for an ordinary share, you calculate a cost of capital using a dividend discount model that is much lower than the calculation for the cost of capital using the CAPM model. Explain a possible source for the discrepancy. (3 marks) (Total = 11 marks)

AFC2140

Page 6 of 10

OFFICE USE ONLY

AFC2140 CORPORATE FINANCE

Question 7 (a) Under Modigliani and Miller’s Proposition 1, where all three of the assumptions remain in effect, explain how the value of the company changes due to changes in the proportion of debt and equity utilised by the company.

(2 marks)

(b) The weighted average cost of capital for a company, assuming all three Modigliani and Miller assumptions hold, is 10 per cent. What is the current cost of equity capital for the company if the cost of debt for the company is 8 per cent, given that the company is financed by 80 per cent debt? (2 marks)

(c) Blackwood Resources has a WACC of 12.6 per cent, and it is subject to a 30 per cent corporate tax rate. Blackwood has $250 million of debt outstanding at an interest rate of 9 per cent and $750 million of equity (market value) outstanding. What is the expected return of the equity given this capital structure? (3 mark)

(d)

Discuss how the legal costs of financial distress may increase with the probability that a company will fall become insolvent, even if the company has not reached the point of insolvency.

(2 marks)

(e) Albatross Ltd is currently valued at $900 million, but management wants to completely pay off its perpetual debt of $300 million. Albatross is subject to a 30 per cent corporate tax rate. If Albatross pays off its debt, what will be the total value of its equity?

(2 marks) (Total = 11 marks)

AFC2140

Page 7 of 10

OFFICE USE ONLY

AFC2140 CORPORATE FINANCE

Question 8 (a) Explain how the repurchase new securities by a company can produce useful information about the issuing company. Why does this information make the shares of the company more valuable, even if this information is confirmation of existing information about the company? (3 marks)

(b)A company announces that it will make a $1.00 dividend payment fully franked at the company tax rate of 30 per cent. Assuming all investors are subject to a 15 percent tax rate on dividends, how much should the company’s share price drop on the ex-dividend date? (2 marks)

(c) Cholla Ltd currently has 30,000 shares outstanding. Each share has a market value of $20. If the company buys back $150,000 worth of shares, what will be the value of each share after the repurchase? Ignore tax.

(3 marks) (d) You are the CFO of a large publicly traded company. You would like to convey positive information about the company to the market. If you intuitively understand (and agree with) the results from the Lintner study, then will you keep paying your currently high dividend or will you raise that dividend by a small amount?

(2 marks) (Total = 10 marks) END OF EXAMINATION

AFC2140

Page 8 of 10

OFFICE USE ONLY

AFC2140 CORPORATE FINANCE

FORMULA SHEETS

FV  P(1  rt)

P0 

FV (1  rt)

PV 

P0 

D0 (1  g ) Rg

V 

P  EPS E

FV  PV (1  i ) n FV PV  (1  i ) n

NPV0 

m

j   i  1    1  m  1 i  i*    1 1  p 

P  i   n   1  P0   1 1 1  i n 



CF (1  i ) n  1 i

FV 

PV  CF  CF i

PV 

PV 



 1  1  (1  i )n    (1 i )k 1

CF i

F (1  i )n

PB 

C 1 1  i  (1  i )n

AFC2140

  

 1 CF   1  n 1  i  (1  i) 

PB 

NCF t

 1  k  t 1

 N CF0

t

Reducing balancerate 

1 n

CF i

n

 T  r  r1   r2  r1 1   T1  T2 

FV  PV  e jn

PV 

D R

 (1  k ) t  NPV  NPV0   t  (1  k )  1 EAV 

NPV 1 1  1  k 1  k t

  

EAV  k  NPV CashFlow DOL  1 

FC EBITDA

Accounting DOL  1 

FC  D & A EBIT

EBITDA Break  Even 

COEBITDA 

 F  n  1  i 

1.5 n

FC Pr ice Unit VC

FC Alternative1  FC Alternative2 UnitContri bution Alternative1 UnitContri bution Alternative 2

EBIT Break  Even 

FC  D & A Pr ice  Unit VC

Page 9 of 10

OFFICE USE ONLY

AFC2140 CORPORATE FINANCE

FORMULA SHEETS (CONTINUED) n

E [ R P ]   wi E ( R i ) i 1

n

E  Ri    pi Ri i 1

n

 2  (Ri  E [R i ]) 2 p i i 1

n

 XY    RXi  E [RX ] RYi  E [RY ] p (R X ,RY ) i 1

 XY 

 XY  X Y

 p2  w1212  w22 22  2w1w2 12 1 2 E ( Ri )  r f   i [ E ( Rm )  r f ]

E ( Rit )  R ft  im [ E( Rmt )  R ft ]  is E[ SMB]  ih E[ HML] n

 p   wi i i 1

i 

Cov (Ri , RM )

 M2

k e  k o  (k o  k d )

D E

VL  VU  t c  D KD 

I VD

k PS 

D PS PPS

K OS  r f  i [E (Rm )  rf ]

K OS 

D1 g P0

te  tC (1  )

kcompany = xDebtkDebt + xEquitykEquity WACC  x Debtk Debtp retax (1 t e )  xpsk ps xOS kOS AFC2140

Page 10 of 10...