Page 1FNCE103: Finance for Law Sample Final Examination Name______________________________________ Student ID No.: ________________ Section: ⃞ G1 (Mon 12:00pm) ⃞ G2 (Tue 3:30pm) ⃞ G3 (Wed 12:00pm) Instructions: Note that your actual exam may differ in format and number of questions asked. This closed-book exam consists of 3 questions. Question 1 consists of 20 multiple-choice questions, which carry 3 marks each. No points will be deducted for selecting an incorrect answer. Please write your best choices for Question 1 in the spaces provided below. Questions 2 and 3 require completely worked out solutions to receive full credit. Please write in the spaces provided. Please limit your work to within the spaces provided. You have two hours to complete the exam. Answer all questions and turn in all pages of the exam paper including your cheat sheet with your name placed on the top right hand corner. Please do not remove any page from the exam paper. Please write your choices to Question 1 here: 1. ___ 6. ___ 11. ___ 16. ___ 2. ___ 7. ___ 12. ___ 17. ___ 3. ___ 8. ___ 13. ___ 18. ___ 4. ___ 9. ___ 14. ___ 19. ___ 5. ___ 10. ___ 15. ___ 20. ___ Question Marks 1. 2. 3. Total: Page 2 Question 1 1. Conglomerate Inc. consists of 2 divisions of equal size, and Conglomerate is 100 percent equity financed. Division A’s cost of equity capital is 9.8 percent, while Division B’s cost of equity capital is 14 percent. Conglomerate’s composite WACC is 11.9 percent. Assume that all Division A projects have the same risk and that all Division B projects have the same risk. However, the projects in Division A are not the same risk as those in Division B. Which of the following projects should Conglomerate accept? A. Division A project with an 11 percent return. B. Division B project with a 12 percent return. C. Division B project with a 13 percent return. D. Statements A and C are correct. 2. An analyst has collected the following information regarding ChrisCo.: The company’s capital structure is 70 percent equity and 30 percent debt. The yield to maturity on the company’s bonds is 9 percent. The company’s year-end dividend is forecasted to be $0.80 a share. The company expects that its dividend will grow at a constant rate of 9 percent a year. The company’s stock price is $25. The company’s tax rate is 40 percent. The company anticipates that it will need to raise new common stock this year, and total flotation costs will equal 10 percent of the amount issued. Assume the company accounts for flotation costs by adjusting the cost of capital. Given this information, calculate the company’s WACC. A. 10.41% B. 12.56% C. 10.78% D. 13.55% 3. If the standard deviation of a diversified portfolio is 20% and if the stocks in that portfolio are positively correlated, then what would we expect the average standard deviation of stocks in that portfolio to be? A. Less than 20% B. 20% C. Greater than 20% D. You would need to know the percentage of each stock invested in that portfolio to determine the answer. 4. Lalit Beauty Products is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's operating cash flow during Year 1? Equipment cost (depreciable basis) $75,000 Straight line depreciation rate 33.33% Sales $60,000 Operating costs excluding depreciation $25,000 Tax rate 35% A. $27,000 B. $28,500 C. $30,000 D. $31,500 Page 3 5. The basic difference(s) between forward and futures contracts is that A. Forward contracts are individually tailored while futures contracts are standardized B. Forward contracts are negotiated with banks whereas futures contracts are bought and sold on an organized exchange C. Forward contracts have no daily limits on price fluctuations whereas futures contracts have a daily limit on price fluctuations D. All of the above 6. Demi and Ashton bought a used car for $1,200 by getting a loan from the Hollywood Bank. They are paying the bank 24 monthly payments of $70. What is the EAR of this loan? A. 40.72% * B. 34.65% C. 44.12% D. 38.12% 7. Today you take out a mortgage in the amount of $189,500 at an annual interest rate of 8.5 percent, compounded monthly. Equal payments are to be made at the end of each month for thirty years. What’s the remaining balance immediately after the first payment? A. $1,342.29 B. $1,457.09 C. $188,042.91 D. $189,385.20 * 8. Oak Furnishings is considering a project that has an up-front cost and a series of positive cash flows. The project’s estimated cash flows are summarized below: Year Project Cash Flow 0 ? 1 $500 million 2 $300 million 3 $400 million 4 $600 million The project has a payback of 2.25 years. What is the project’s internal rate of return (IRR)? A. 23.1% B. 17.7% C. 33.5% * D. 41.0% 9. What is the standard deviation of the returns for Adore talent agency if the return distribution is as follows? Probability Return 0.25 0.25 0.35 0.15 0.40 -0.08 A. 1.92% B. 15.15% C. 19.2% D. 13.85% * Sales revenues $60,000 - Operating costs (x-depr) -$25,000 - Basis x rate = depreciation = -$25,000 Operating income (EBIT) $10,000 - Taxes -$3,500 After-tax EBIT $6,500 + Depreciation $25,000 Operating cash flow, Year 1 $31,500 Page 4 10. Stock A is currently trading at $50 per share. The stock’s dividend is expected to grow at a constant rate of 5% per year. The required rate of return for stock A is 10%. What is the expected price of stock A 5 years from now? A. 63.81 * B. 80.53 C. 75.35 D. 100 11. As the number of securities in a portfolio is increased, what happens to the average portfolio standard deviation? A. It increases at an increasing rate. B. It increases at a decreasing rate. C. It decreases at an increasing rate. D. It decreases at a decreasing rate. * E. It first decreases, then starts to increase as more securities are added. 12. Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15 percent, a beta of 1.6, and a standard deviation of 30 percent. The returns of the two stocks are independent--the correlation coefficient is zero. Which of the following statements best describes the characteristics of your portfolio? A. Your portfolio has a beta equal to 1.6 and its expected return is 15 percent. * B. Your portfolio has a standard deviation of 30 percent and its expected return is 15 percent. C. Your portfolio has a standard deviation less than 30 percent and its beta is greater than 1.6. D. Your portfolio has a standard deviation greater than 30 percent and a beta equal to 1.6. E. Your portfolio has a beta greater than 1.6 and an expected return greater than 15 percent. 13. The Food and Drug Administration (FDA) just announced yesterday that they would approve a new cancer-fighting drug from King. King has a beta of 1.7. The annualized market return yesterday was 13%, and the annualized risk-free rate was 3% yesterday. You observe that King had an annualized return yesterday of 20%. Which of the following is more likely? A. The market reviewed the approval as a good surprise. B. King stock will probably rise in value tomorrow. C. King stock will probably fall in value tomorrow. D. The approval was already anticipated by the market. * E. The approval was not good enough for the market. 14. A 12-year bond pays an annual coupon of 8.5 percent. The bond has a yield to maturity of 9.5 percent and a par value of $1,000. What is the bond’s current yield? A. 6.36% B. 2.15% C. 8.95% D. 9.14% * E. 10.21% 15. Co. is trying to estimate its weighted average cost of capital (WACC). Which of the following statements is most correct? A. The after-tax unit cost of debt is generally cheaper than the after-tax unit cost of stock. B. Since retained earnings are readily available, the cost of retained earnings is generally lower than the cost of debt. C. If the company’s beta increases, this will increase the cost of equity financing, even if the company is able to rely on only retained earnings for its equity financing. D. Statements a and b are correct. E. Statements a and c are correct. * Page 5 16. Consider two bonds, F and G. Both bonds presently are selling at their par value of $1,000. Each pays interest of $90 annually. Bond F will mature in 15 years while bond G will mature in 26 years. If the yields to maturity on the two bonds change from 9% to 10%, ____________. A. both bonds will increase in value, but bond F will increase more than bond G B. both bonds will increase in value, but bond G will increase more than bond F C. both bonds will decrease in value, but bond F will decrease more than bond G D. both bonds will decrease in value, but bond G will decrease more than bond F E. none of the above 17. Pewter & Glass is an all equity firm that has 80,000 shares of stock outstanding. The company is in the process of borrowing $600,000 at 9 percent interest to repurchase 12,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes? A. $2.5 million B. $4.0 million * C. $5.0 million D. $5.5 million E. $6.0 million 18. The market price of Simpson Structures stock has been relatively volatile and you think this volatility will continue for a couple more months. Thus, you decide to purchase a two-month European call option on this stock with a strike price of $32.50 and an option price of $1.80. You also purchase a two-month European put option on the stock with a strike price of $32.50 and an option price of $.60. What will be your net profit or loss on these option positions if the stock price is $34.20 on the day the options expire? Note that each contract is on 100 shares of the underlying stock. Ignore trading costs and taxes. A. $130 B. $120 C. $70* D. $60 E. $10 19. DEF Company has a capital structure with debt (long-term bonds) and common equity. The debt to equity ratio is 3/7. The yield to maturity on the bonds is 8%, and the firm estimates that its overall composite WACC is 10%. The risk-free rate is 5.5%, the market risk premium is 5%, and the company’s tax rate is 40%. DEF uses the CAPM to determine its cost of equity. What is the beta on DEF’s stock? A. 1.07 B. 1.48 C. 1.31 D. 0.10 E. 1.35 * 20. Project A has an IRR of 15 percent. Project B has an IRR of 18 percent. Both projects have the same systematic risk and normal cash flows. Which of the following statements is most correct? A. If the WACC is 10 percent, both projects will have a positive NPV, and the NPV of Project B will exceed the NPV of Project A. B. If the WACC is 15 percent, the NPV of Project B will exceed the NPV of Project A. * C. If the WACC is less than 18 percent, Project B will always have a shorter payback than Project A. D. If the WACC is greater than 18 percent, Project B will always have a shorter payback than Project A. E. If the WACC increases, the IRR of both projects will decline. Page 6 Question 2 Napamon recently took her company public through an initial public offering. She is expanding the business quickly to take advantage of an otherwise unexploited market. Growth for her company is expected to be 40 percent in the first three years and then she expects it to slow down to a constant 15 percent thereafter. The most recent dividend (D 0 ) was $0.75. Based on the most recent returns, her company’s beta is approximately 1.5. The risk-free rate is 8 percent and the market risk premium is 6 percent. (20 marks) (a) What is your estimate the company’s cost of equity? k s = k RF + RP M (b) = 8% + 6%(1.5) = 17%. (b) Estimate the expected dividends that the company will pay at the end of year 1 through year 4, i.e., D 1 , D 2 , D 3 and D 4 . D 1 = $0.75(1.4) = $1.05. D 2 = $0.75(1.4) 2 = $1.47. D 3 = $0.75(1.4) 3 = $2.058. D 4 = $0.75(1.4) 3 (1.15) = $2.3667. (c) Estimate the intrinsic value of the company’s stock per share. 3 P ˆ = D 4 /k s - g = $2.3667/(0.17 - 0.15) = $118.335. P 0 = 1.17 $1.05 + ) (1.17 $1.47 2 + ) (1.17 $118.335 + $2.058 3 = $77.14. (d) If the stock is currently trading at $70, would you recommend its purchase? Why? Buy: stock is underpriced by the market. Page 7 Question 3 The ECG Development Co. is considering a project with the following after-tax operating cash flows (in millions of dollars): Project Year Cash Flow 0 -$300 1 125 2 75 3 200 4 100 Assuming that the project has a WACC of 10%, please answer the following questions. Hint: Please show your complete set-up for each part to receive full credit. (20 marks) (a) Compute and very briefly explain the meaning of the project’s IRR. CF 0 = -300; CF 1 = 125; CF 2 = 75; CF 3 = 200; CF 4 = 100; and then solve for IRR = 23.42%. (b) Compute and very briefly explain the meaning of the project’s NPV. CF 0 = -300; CF 1 = 125; CF 2 = 75; CF 3 = 200; CF 4 = 100; I/YR = 10; and solve for NPV = 94.18 = $94.18 million. (c) Compute and very briefly explain the meaning of the project’s discounted payback period. Find the PVs of the cash flows using the firm’s 10% WACC. Discounted Year Cash Flow Cash Flow @ 10% Cumulative PV 0 -$300 -$300.00 -$300.00 1 125 125/1.10 = 113.64 -186.36 2 75 75/(1.10) 2 = 61.98 -124.38 3 200 200/(1.10) 3 = 150.26 +25.88 4 100 100/(1.10) 4 = 68.30 +94.18 Therefore, the project’s discounted payback is 2 + 26 . 150 $ 38 . 124 $ = 2.83 years. (d) Compute and very briefly explain the meaning of the project’s Modified IRR (MIRR). To calculate the MIRR, we need to find the PV of all the outflows and the FV of all the inflows. The discount rate that equates the two is the MIRR. PV of inflows FV of outflows -$300 $125 1.10 3 = $166.375 $ 75 1.10 2 = 90.750 $200 1.10 1 = 220.000 $100 1.10 0 = 100.000 $577.125 N = 4; PV = -300; PMT = 0; FV = 577.125; and then solve for I/YR = MIRR = 17.77%. (e) Should the project be accepted? Please justify your answer with the appropriate arguments. How would acceptance or rejection of the project affect the shareholders of the firm? Explain. Accept, +NPV, IRR and MIRR>WACC, adds to shareholder wealth.
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