Practice Test 2 Answers PDF

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THE UNIVERSITY OF AUCKLAND FINANCE 251 FINANCIAL MANAGEMENT MID-SEMESTER TEST 2013 S2 Campus: City

(Time allowed: 90 minutes plus 5 minutes reading time)

Solutions

Note: Formulae and PV Tables were attached in the Appendix.

MULTIPLE CHOICE ANSWER SHEET Section I: Answer Question (A), (B), (C) or (D) 1 B 2

D

3

C

4

B

5

C

6

A

7

C

8

B

9

C

10

A

2

END

Name:………………………………….. AUID:………………………………….

SECTION I:

MULTIPLE CHOICE QUESTIONS

FINANCE 251

(20 Marks)

Choose the best answer for each question. Write your choice - (A), (B), (C) or (D) in the appropriate box on page 2. Each question is worth 2 marks.

1. Agency problems can best be characterized as: A. dislike of firm's bondholders by its equity holders. B. differing incentives between managers and owners. C. spending of corporate resources. D. friction between the primary and secondary markets. 2. A bond differs from a share of stock in that: A. a bond represents a claim on the firm. B. a bond has more risk. C. a bond has guaranteed returns. D. a bond has a maturity date. 3. Perhaps the best method for estimating the market value of shareholders' equity is to: A. read from the firm's balance sheet. B. read from the firm's income statement. C. multiply number of shares outstanding by the price of each share. D. add the retained earnings plus total liabilities. 4. The concept of compound interest refers to: A. earning interest on the original investment. B. payment of interest on previously earned interest. C. investing for a multiyear period of time. D. determining the APR of the investment. 5. How much will accumulate in an account with an initial deposit of $100, and which earns 10% interest compounded quarterly for 3 years? A. $107.69 B. $133.10 C. $134.49 D. $313.84

Name:………………………………….. AUID:………………………………….

FINANCE 251

6. How much more would you be willing to pay today for an investment offering $10,000 in 4 years rather than the normally advertised 5-year period? Your discount rate is 8%. A. $544.47 B. $681.48 C. $740.74 D. $800.00 7. What happens to the coupon rate of a $1,000 FV bond that pays $80 annually in interest if interest rates change from 9% to 10%? A. The coupon rate increases to 10%. B. The coupon rate remains at 9%. C. The coupon rate remains at 8%. D. The coupon rate decreases to 8%. 8. Common stock can be valued using the perpetuity valuation formula if the: A. discount rate is expected to remain constant. B. dividends are not expected to grow. C. growth rate in dividends is not constant. D. investor does not intend to sell the stock. 9. What constant-growth rate in dividends is expected for a stock valued at $32.00 if next year's dividend is forecast at $2.00 and the appropriate discount rate is 13%? A. 5.00% B. 6.25% C. 6.75% D. 15.38% 10. Which of the following changes will increase the NPV of a project? A. A decrease in the discount rate B. A decrease in the size of the cash inflows C. An increase in the initial cost of the project D. A decrease in the number of cash inflows

Name:………………………………….. AUID:………………………………….

FINANCE 251

Section II COMPUTATIONAL QUESTIONS (60 Marks) Clearly show ALL workings 1. Prizes are often not "worth" as much as claimed. Place a value on a prize of $5,000,000 which is to be received in equal payments over 20 years, with the first payment beginning today. Assume an interest rate of 7% over the 20 years. (8 marks)

2. Would you prefer a savings account that paid 7% interest, compounded quarterly, over an account that paid 7.5% with annual compounding if you had $1,000 to deposit? Would the answer change if you had $100,000 to deposit? (8 marks) FV = (1 + i)n for simple interest FV = (1 + i/m)nxm for compound interest Then, FV = (1 + .07/4)1 x 4 = 1.0719 Versus FV = (1 + 0.75)1 = 1.075 Thus, the 7.5% account will earn .31% more in the first year than the 7% account with quarterly compounding. The amount to be deposited will not change your preference: In this case the compounding is not enough to overcome the difference in APR.

Name:………………………………….. AUID:………………………………….

FINANCE 251

3. What is the coupon rate for a $1,000 FV bond with 3 years until maturity, a price of $1,053.46, and a yield to maturity of 6%? (8 marks)

4. How much should you pay for a $1,000 bond with 10% coupon, annual payments, and 5 years to maturity if the interest rate is 12%? (6 marks)

Name:………………………………….. AUID:………………………………….

FINANCE 251

5. What is the required return for a stock that has a 6% constant-growth rate, a price of $25, an expected dividend of $2, and a P/E ratio of 10? (6 marks)

$25 = 2/(r - .06) r = 14% (P/E ratio is a red herring)

6. For a firm that expects earnings next year of $10.00 per share, has a plowback ratio of 35%, a return on equity of 20%, and a required return of 15%, show the current stock value and next year's expected stock value, assuming that growth is to be constant. (9 marks)

FINANCE 251

Name:………………………………….. AUID:………………………………….

Clean Corp Ltd is considering a proposal to invest in a sterilising machine with an initial cost of $200,000, which is to be depreciated straight-line over 5 years to an expected salvage value of $20,000. The company’s revenue is expected to increase by $90,000 a year for 5 years due to increases in recording contracts. The company’s expenses are also estimated to increase by $30,000 a year during the 5-year project. Corporate tax rate is 28% and the appropriate cost of capital for this project is 12%. Note: you must show all workings. 7. Calculate the project's cash flows. Description

Year 0

Initial Investment

(9 marks) Year 5

Year 1-4

-$200,000

Increased Revenue

$90,000

$90,000

Increased Expenses

-$30,000

-$30,000

Depreciation

-$36,000

-36,000

EBT

$24,000

$24,000

Tax

-$6,720

-$6,720

EAT

$17,280

$17,280

Add back Depn

$36,000

$36,000

Recovery Value

$20,000

Net Cash Flows

-$200,000

$53,280

$73,280

Workings Depn = (Cost-Resid)/Life = ($200,000 - $20,000) / 5 = $36,000 Tax = $24,000 x 28% = $6,720 OR Year Investment Revenue Expenses Deprn EBIT Tax NPAT Scrap Cash Flow

0 -200000

-200000

1

2

3

4

5

90000 30000 36000 24000 6720 17280

180000 60000 36000 84000 23520 60480

270000 90000 36000 144000 40320 103680

360000 120000 36000 204000 57120 146880

53280

96480

139680

182880

450000 150000 36000 264000 73920 190080 20000 246080

FINANCE 251

Name:………………………………….. AUID:………………………………….

8. Calculate the project's NPV and suggest if Clean Corp Ltd should accept the project. (6 marks)

Period CF PVIF PV NPV

0 -200000 1 -200000 $3,411.01

1 53280 0.8929 47574

2 53280 0.7972 42475

3 53280 0.7118 37925

4 53280 0.6355 33859

5 73280 0.5674 41579

NPV > $0  should accept the project If question is interpreted to mean annual incremental revenues instead of revenues being higher for 5 years (which is what was meant) then: Cash Flow NPV

-200000 $279,762

53280

96480

139680

182880

246080

FINANCE 251

Name:………………………………….. AUID:…………………………………. SECTION III: WRITTEN QUESTIONS 1.

(20 Marks)

Describe agency problems in general, and offer at least three examples from corporations. (8 marks)

Whenever the firm's managers are different than the firm's owners, the potential exists for agency problems. Management may be taking advantage of the fact that corporate ownership is often quite diverse, such that none of the owners appears to be "minding the store." In those cases, it may be easy for top management to    

vote itself an excessive raise, or to redecorate the corporate suite, or to be lax on the justification of expense reports, or even to invest in projects that are "too safe."

Why might managers choose safe projects? For example, the executive may have one year remaining on an employment contract and be more concerned with stable profits than with rising profits.

Name:………………………………….. AUID:…………………………………. 2.

FINANCE 251

Why are long-term bonds more sensitive to changes in interest rates than shortterm bonds? (6 marks)

A long-term bond is more sensitive to changes in interest rates simply because there are more coupon payments and longer time periods for each cash flow to be affected by the changed interest rate. Remembering that bond prices are determined by the sum of a present value of an annuity and the present value of a future amount, when those formulas experience different discount rates for longer periods, there is substantially more effect.

2.

How can an analyst feel comfortable in stating that the value of a stock is equal to the discounted value of all future dividends when a company may pay dividends indefinitely and it is virtually impossible to predict dividends beyond some reasonable horizon? (6 marks)

At most reasonable discount rates for common stock, say between 10% and 20%, the present value of dividends to be received beyond some reasonable horizon, say 10 years, is quite low in relation to the present value of dividends received to that point. For example, for a stock expecting to pay a dividend of $2.00 with a growth rate of 5% and a required return of 15%, approximately 60% of the present value of an infinite dividend stream is realized from the first 10 years of dividends. By 15 years, approximately 75% of future value has been received. These percentages can easily be proven by use of the constant growth dividend discount model...