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ACF214M: Term Test

Section A: Multiple-choice questions

ANSWER ALL QUESTIONS [10*4 Marks]

1.   An investor purchased 200 shares of a stock for £100 per share at the beginning of a quarter. The investor sold all these shares for £80 per share after receiving a total £500 dividend payment at the end of the quarter. The quarterly total return is closet to

a.   -18.5%

b.   -17.5%

c.   -16.5%

d.   -15.5%

2.   A portfolio manager creates the following portfolio: 

Security       Security Weight          Expected Standard Deviation      

1

2

0.20

0.80

0.35

0.15

If the correlation of returns between the two securities is -0.30, the expected standard deviation of the portfolio is closest to

a.    14.8%

b.    13.9%

c.    12.8%

d.   11.9%

3.   Complete the following sentence: A decrease in the sales of a current project because of the launching of a new project is

a.   irrelevant to the investment decision

b.   cannibalization

c.   an overhead expense

d.   a sunk cost

4.   When all investors correctly interpret and use their own information, as well as information that can be inferred from market prices or the trades of others, they are said to have

a.   sensation seeking expectations

b.   positive expectations

c.   rational expectations

d.   confident expectations

5.   There are different forms of market efficiency. In a market, the market price of any asset reflects all information contained in the history of past prices. This form of efficiency is

a.   semi-weak form

b.   weak form

c.   semi-strong form

d.   strong form

6.   A firm is considering a project that requires £2.0 million as initial capital expenditures. Its annual benefit is £1.6 million in each of the following two years and then the project ends. Assume the annual discount rate is 8%. The NPV of this project is closest to

a.   £0.65 million

b.   £0.75 million

c.   £0.85 million

d.   £0.95 million

7.   An analysis that breaks the NPV calculation into its component assumptions and shows how the NPV varies as one of the underlying assumptions is changed is called

a.   IRR analysis

b.   scenario analysis

c.   accounting break-even analysis

d.   sensitivity analysis

8.   Which of the following would increase the net working capital?

a.   Decrease in inventory

b.   Decrease in fixed asset

c.   Decrease in accounts receivable

d.   Decrease in accounts payable

9.   An efficient portfolio

I)  has no risk

II) has only unique risk

III) provides the highest expected return for a given level of risk

IV) provides the least risk for a given level of expected return

a.   I only

b.   I and III only

c.   II and IV only

d.   III and IV only

10. Which statement about the Capital Asset Pricing Model (CAPM) is not correct?

a.   Investors can buy and sell all securities at competitive market prices

b.   Investors have homogeneous expectations

c.   Unique risk is priced

d.   Market risk is priced


Section B

ANSWER ALL QUESTIONS [30 Marks + 30 Marks]

11. Kent Quest Industries is considering investing in a machine that will cost $100,000 and will last for four years. The machine will generate revenues of $120,000 each year and the cost of goods sold will be 60% of sales. At the end of year four the machine will be sold for $15,000. The      appropriate cost of capital is 12% and Kent Quest is in the 35% tax bracket.

Assume that Kent Quest Industries' new machine will be depreciated straight line to a book value of $5000 at the end of year four.

a.   Calculate the total Free Cash Flows for each of the four years for the Kent Quest Industries’ new project.

Year

0

1

2

3

4

Sales

Cost of Goods Depreciation       EBIT

Tax @ 35%

=NI

 

120,000

72,000

 

23,750

 

24,250

 

8,487.5

 

15,762.5

120,000

72,000

 

23,750

 

24,250

 

8,487.5

 

15,762.5

120,000

72,000

 

23,750

 

24,250

 

8,487.5

 

15,762.5

120,000 72,000 23,750 24,250 8,487.5

15,762.5

+D

+CapEx

+Liquidation

 

 

- 100,000

23,750

23,750

23,750

23,750

 

 

 

11,500

FCF

- 100,000

39512.5

39512.5

39512.5

51012.5

PV

- 100,000

35279.02

31499.12

28124.22

32419.37

5 marks for liquidation value = 15,000 − (15,000 − 5,000) ∗ 0.35 = 11,500;

15 marks of correct Free Cash Flow, which consists of + 3 marks for CapEx (100,000)

+ 3 marks for correct depreciation ((100,000-5,000)/4=23,750)

+ 3 marks for correct treatment of Depreciation when OCF is calculated (when students didn’t forget to add depreciation back to the net income figure, i.e. OCF=15,762.5+23,750). The students may use alternative methods such as tax shield approach when they calculate OCF.

+ 3 marks for EBIT (S-C-D=24,250)

+ 3 for Net Income (24,250*(1-0.35)= 15,762.5;

a.   What is the NPV for this project?

+10 marks for correct NPV calculation:

 = −100,000 +  +  +  +  = 27321.723

12. Tiffany  is the  head  portfolio  manager  of the global  equities  portfolio  at  Phi Delta,  an  asset management firm. Steve Smith, a recently hired equity analyst, has been assigned to Phi Delta to assist her with the portfolio. Tiffany asks Smith to evaluate Copper Industries, a privately owned U.S. company that may initiate a public stock offering. Smith decides to use CAPM to estimate the required return on equity for Copper Industries. Smith identifies a publicly traded peer company with an estimated equity beta of 2.15. Copper Industries is funded 25% by debt and 75% by equity. The publicly traded peer company is funded 60% by debt and 40% by equity. The risk-free rate is 1%. The average return on the S&P 500 index for the past 5 years is 8.3%. Assume that debt is risk- less and there is no tax.

a.    Estimate equity beta for Copper Industries.

[15 marks]

Solution:

The beta of the benchmark peer company data is given as 2.15. Next, this beta needs to be unlevered, calculated as:

 = ()    = () 2. 15 = 0.86       (8 marks)

Then, the unlevered beta needs to be levered up to reflect the financial leverage of Twin Industries, calculated as:

    = (1 + )  = (1 + ) 0.86 = 1. 1467   (7 marks)

b.   What is the required return on equity for Copper Industries?

[15 marks]

Solution:

Required return on equity = 0.01 + 1. 1467 × (0.083 − 0.01) = 0.0937091 or 9.371%