FINA 3332 Practice questions Exam 3 Solutions PDF

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FINANCE 3332 Principles of Financial Management Practice Questions – Exam 31 Suggested Solutions

Chapter 7: Stock Valuation QUESTION 1: You placed an order to purchase stock where you specified the maximum price you were willing to pay. This type of order is known as a ________. A) maximum order B) limit order C) floor order D) market order ANSWER: B (No explanation necessary)

QUESTION 2: “Super Honest Company” (SH) has a current stock price of $3.00 and is expected to sell for $3.15 in one year's time, immediately after it pays a dividend of $0.28. Which of the following is closest to SH's equity cost of capital? A) 7.17% B) 8.60% C) 14.33% D) 17.91% ANSWER: C (No explanation necessary) rE = Dividend yield + Capital gains rate (you could recover this definition from the general dividend model formula) rE = 0.28/3.00 + (3.15-3.00)/3.00 = 0.09333 + 0.05 = 0.14333 = 14.33%

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Questions are not arranged in the order of difficulty.

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*For registered students only. DO NOT copy or distribute* QUESTION 3: Which of the following statements is FALSE regarding profitable and unprofitable growth? A) If a firm wants to increase its share price, it must diversify. B) If a firm retains more earnings, it will pay out less of those earnings, reducing its dividends. C) A firm can increase its growth rate by retaining more of its earnings. D) Cutting a firm's dividend to increase investment will raise the stock price if the new investment has a positive net present value (NPV). ANSWER: A (No explanation necessary) QUESTION 4: Jumbo Transport, an air-cargo company, expects to have earnings per share of $2.00 in the coming year. It decides to retain 10% of these earnings in order to lease new aircraft. The return on this investment will be 25%. If its equity cost of capital is 11%, what is the expected share price of Jumbo Transport? ANSWER: $21.18 (Provide calculations) Applying the formula:  

   

Div1 = $2.00 × (1 - 0.1) = $1.8 g = 0.1 × 0.25 = 0.025 P0 = $1.8 / (0.11 - 0.025) = $21.18 QUESTION 5: JRN Enterprises just announced that it plans to cut its dividend from $3.00 to $1.50 per share and use the extra funds to expand its operations. Prior to this announcement, JRN's dividends were expected to grow indefinitely at 4% per year and JRN's stock was trading at $25.50 per share. With the new expansion, JRN's dividends are expected to grow at 8% per year indefinitely. Assuming that JRN's risk is unchanged by the expansion, what is the value of a share of JRN after the announcement? ANSWER: $19.32 (Provide calculations) Step 1: Solve for rE:

Step 2: Solve for new stock price:

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*For registered students only. DO NOT copy or distribute* QUESTION 6: “Bayer2 Pharma” is expecting a growth rate of 14% for the next two years (t=1 and t=2) due to its new drug. Thereafter it should level to an 8% growth rate. The last dividend paid (i.e. D 0 ) was $0.65 per share. What price should the stock sell for today if the equity cost of capital is 12%? ANSWER: $19.52 (Provide calculations) This question requires the use of the dividend model with changing growth rates:  

  1    × + + …+ +        1 +   1 +   1 +  1 +  

Step 1: Calculate the PV of the “High Growth” period dividends (first 2 years):    × 1 +  $0.65 × 1 + 0.14 $0.741

    × 1 +   $0.65 × 1 + 0.14



$0.84474

  

 $0.741  $0.6616  1 + 0.12  1 +  

   

$0.84474   $0.6734 1 +   1 + 0.12 

Step 2: Using the constant growth model, calculate the Price at the end of the “High Growth” period, i.e. the price at (the end of) year 2, using the growth rate at the second stage, g=8%

 

#   

 = 0.08 # =$0.84474x(1.08) = 0.9123;   = 0.12  

$0.9123

$22.8075 0.12  0.08

Next, calculate the PV of this price:    

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$22.8075   $18.182 1 +    1 + 0.12 

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*For registered students only. DO NOT copy or distribute* Step 3: Compute the current value of common stock,  , by adding up both components:    %&' 2 ()*& +,,)-,& +     $0.6616 + $0.6734 + $18.182$./. 0.1

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*For registered students only. DO NOT copy or distribute* Chapter 8: Investment Decision Rules QUESTION 1: A farmer sows a certain crop. At t=0, it costs $240,000 to buy the seed, prepare the ground, and sow the crop. In one year's time (at t=1) it will cost $93,200 to harvest the crop. If the crop will be worth $350,000 at t=1, and the interest rate is 7%, what is the net present value (NPV) of this investment? ANSWER: NPV = $0 (Provide calculations) Using the definition:

2   3)-)%'&   45&'&

$350,000 $327,102.80  3)-)%'&  1.07 $93,200 + 240,000 $327,102.80  45&'&  1.07 2  $327,102.80  $327,102.80  0 QUESTION 2: Which of the following statements is FALSE? A) In general, the difference between the cost of capital and the internal rate of return (IRR) is the maximum amount of estimation error in the cost of capital estimate that can exist without altering the original decision. B) The internal rate of return (IRR) can provide information on how sensitive your analysis is to errors in the estimate of your cost of capital. C) If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate. D) If the cost of capital estimate is more than the internal rate of return (IRR), the net present value (NPV) will be positive. ANSWER: D (No explanation necessary)

QUESTION 3: Which of the following is NOT a limitation of the payback rule? A) It does not consider the time value of money. B) Lacks a decision criterion that is economically based. C) It is difficult to calculate. D) It does not consider cash flows occurring after the payback period ANSWER: C (No explanation necessary)

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*For registered students only. DO NOT copy or distribute* QUESTION 4: Investment A: Year: Cash flow:

0 1 -$14,000 $6000

2 $6000

3 $6000

4 5 $6000 $6000

Investment B: Year: Cash flow:

0 1 -$15,000 $7000

2 $7000

3 $7000

4 5 $7000 $7000

Investment C: Year: Cash flow:

0 1 -$18,000 $12,000

2 $2000

3 $2000

4 5 $2000 $2000

The cash flows for three projects are shown above. The cost of capital is 9.5%. If an investor decided to take projects with a payback period two years or less, will she take any of the projects? If so, which one(s)? ANSWER: (Provide calculations or an explanation) The payback period for all projects is higher than 2 years. Therefore, the investor would not take any of the projects by applying the payback rule with a payback period of two years or less.

QUESTION 5: An investor has the opportunity to invest in a new retail store, requiring an initial investment of $60,000. It is assumed that the store will operate in perpetuity after the initial investment. The investment will generate an expected cash flow at the end of the first year of $6,000, and the expected cash flow will grow by 2.5% per year. The cost of capital is 7.2%. According to the IRR rule should the investor accept this opportunity? ANSWER: YES (Provide calculations) Since the cash flows are in perpetuity, we can calculate the IRR in this problem – the IRR is the discount r that makes the NPV = 0: 2 

$6,000  $60,0000 ↔ 788  0.025

$6,000$60,000 × 788  0.025 $60,000 × 788  $6,000 + $1,500 $60,000 × 788  $7,500 788

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$7,500  0.125 5 12.5% $60,000

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*For registered students only. DO NOT copy or distribute*

Since the IRR > cost of capital, the investor should accept this opportunity (note that cash flows are standard cash flows and therefore we can apply the IRR rule).

QUESTION 6: Use the table for the question below. Consider the following list of projects: Project A B C D E F G H I

Investment $135,000 200,000 125,000 150,000 175,000 75,000 80,000 200,000 50,000

NPV $6,000 30,000 20,000 2,000 10,000 10,000 9,000 20,000 4,000

Assuming that your capital is constrained, which project should you invest in first? ANSWER: Project C (Provide calculations) Applying the definition of profitability index to each alternative: 2 5%'*3;'( 7-,)<  8)&5=4) >5-&=?), Project A B C D E F G H I

Investment $135,000 200,000 125,000 150,000 175,000 75,000 80,000 200,000 50,000

NPV $6,000 30,000 20,000 2,000 10,000 10,000 9,000 20,000 4,000

Profitability Index 0.0444 0.1500 0.1600 0.0133 0.0571 0.1333 0.1125 0.1000 0.0800

Rank 8 2 1 9 7 3 4 5 6

We would invest first on the project ranked as 1, i.e. project C

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*For registered students only. DO NOT copy or distribute* Chapter 11: Risk and Return in Capital Markets QUESTION 1: Investments with high returns are expected to have ________. A) high risk B) low risk C) no relation with risk D) low bid-ask spread ANSWER: A (No explanation necessary)

QUESTION 2: Suppose you invested $60 in the Ishares Dividend Stock Fund (DVY) a month ago. It paid a dividend of $0.63 today and then you sold it for $65. What was your return on the investment? ANSWER: 9.38% (Provide calculations) Applying the formula: 8 @ 

@ @  @ + @ @

8 @ 

$0.63 $65  $60  0.0105 + 0.0833  0.0938 5 9.38% + $60 $60

QUESTION 3: Ford Motor Company had realized returns of 20%, 30%, 30%, and 20% over four years. What is the (yearly) standard deviation of returns for Ford calculated from this sample? ANSWER: 5.77% (Provide calculations) We first compute the average return by applying the formula: 1 8A  8 + 8  + ⋯ + 8 D  B 8A 

1 0.2 + 0.3 + 0.3 + 0.2  0.25 5 25% 4

Then, we compute the variance: 1 8   8A   + 8   8A   + ⋯ + 8 D  8A    *8  B1 *8 

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1 0.2  0.25  + 0.3  0.25  + 0.3  0.25  + 0.2  0.25  0.003333 3 8

*For registered students only. DO NOT copy or distribute* E8  F *8 = 0.05774 (or 5.77%) QUESTION 4: A company's stock price jumped when it announced that its revenue had decreased because of the quality issues of its products. This is an example of ________. A) market risk B) unsystematic risk C) systematic risk D) undiversifiable risk ANSWER: B (No explanation necessary)

QUESTION 5: Which of the following is NOT a systematic risk? A) the risk that oil prices rise, increasing production costs B) the risk that the economy slows, reducing demand for your firm's products C) the risk that your new product will not receive regulatory approval D) the risk that the Federal Reserve raises interest rates ANSWER: C (No explanation necessary)

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*For registered students only. DO NOT copy or distribute* Chapter 12: Systematic Risk and the Equity Risk Premium QUESTION 1: The volatility of Home Depot share prices is 30% and that of General Motors shares is 30%. When I hold both stocks in my portfolio and the stocks returns have a correlation of 1, the overall volatility of returns of the portfolio is ________. A) more than 15% B) less than 30% C) unchanged at 30% D) equal to 15% ANSWER: C (No explanation necessary) QUESTION 2: Diversification reduces the risk of a portfolio because ________, and some of the risks are averaged out of the portfolio. A) stocks do not move identically B) stocks have common risks C) stocks are fully predictable D) stocks are not affected by the market ANSWER: A (No explanation necessary) QUESTION 3: You expect General Motors (GM) to have a beta of 1 over the next year and the beta of Exxon Mobil (XOM) to be 1.2 over the next year. Also, you expect the volatility of General Motors to be 30% and that of Exxon Mobil to be 40% over the next year. Which stock has more systematic risk? Which stock has more total risk? ANSWER: XOM, XOM (Provide an explanation) Systematic risk is measured by beta. XOM has a higher beta, therefore more systematic risk. Total risk is measured by volatility. XOM has higher volatility, therefore more total risk.

QUESTION 4: Your estimate of the market risk premium is 9%. The risk-free rate of return is 3.8% and General Motors has a beta of 1.4. According to the Capital Asset Pricing Model (CAPM), what is General Motors’ expected return? ANSWER: 16.4% (Provide calculations) Applying the CAPM equation:

G[8 I]

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K

+ LI G[8 MN@ ]  K

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*For registered students only. DO NOT copy or distribute* G[8 I] 3.8% + 1.49% 16.4% QUESTION 5: You are analyzing a stock that has a beta of 1.2. The risk-free rate is 5% and you estimate the market risk premium to be 6%. If you expect the stock to have a return of 11% over the next year, should you buy it? Why or why not? ANSWER: NO (Provide calculations and a short explanation) Compute what the expected return for a stock with a beta of 1.2 should be according to the CAPM equation. Expected Return = 5% + 1.2 × (6%) = 12.2% No, you should not buy the stock. According to the CAPM, you should expect a return of 12.2% for taking on an investment with a beta of 1.2. But because this stock only returns 11%, it does not fully compensate you for the risk of the stock, and you can find other investments that will return 11% with less risk.

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