BFF2140 CORPORATE FINANCE I
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BFF2140 CORPORATE FINANCE I
PRACTICE QUESTIONS FOR FINAL EXAM-SOLUTIONS
SECTION A: MULTIPLE-CHOICE QUESTIONS
Question 1:
Andjelkovic-Stewart Limited Company borrows $1 million short-term, $10,000 long-term and invests these proceeds in inventory. Identifying the impact on working capital and/or cash, which of the following statements is TRUE?
A. Increase in working capital
B. No change in working capital
C. Decrease in working capital
D. No change in working capital and no change in cash.
ANSWER: A
Recall WC = Current Assets – Current Liabilities.
Current Assets increase by $1.01 million (cash in $1 million plus $10,000) while Current Liabilities increase by $1 million only (long term liabilities are not accountedfor in WC).
As a result, WC increases by $10,000.
Question 2:
Which of the following is a reason why incremental earnings may be different from incremental cash flows?
A. Changes in accounts receivable reflects non-cash sales present in incremental earnings that are not in incremental cash flows.
B. Depreciation is a cash expense, but does not appear in incremental earnings.
C. Capital expenditures appear on the income statement. However, as these costs are depreciated over time, they should not be present in incremental cash flows.
D. Firms pay taxes based on incremental cash flows, not incremental earnings.
ANSWER: A
Combining learning from Lecture 5 (capital budgeting) and Lecture 7 (NWC management)
Question 3:
In order to use the WACC to evaluate a future project's cash flows, which of the following must hold?
A. The project will be financed with the same proportion of debt and equity as the company.
B. The systematic risk of the project is the same as the overall systematic risk of the company.
C. The project must be viable.
D. A and B above.
ANSWER: D
Refer to Lecture 10.
Question 4:
According to M&M Proposition 2, the cost of a company's equity
A. increases with the debt-to-equity ratio.
B. decreases with the debt-to-equity ratio.
C. increases and then falls with the debt-to-equity ratio.
D. decreases and then increases with the debt-to-equity ratio.
ANSWER: A
Refer to Lecture 11.
Question 5:
Which of the following statements regarding international projects is FALSE?
A) Interest rates and costs of capital will likely be different in the foreign country as a result of the macroeconomic environment.
B) The firm will probably face a different tax rate in the foreign country and will be subject to both foreign and domestic tax codes.
C) The project will most likely generate home currency cash flows, although the firm cares about the foreign currency value of the project.
D) Under internationally integrated capital markets, the value of an investment does not depend on the currency we use in the analysis.
ANSWER: C
Refer to Lecture 7.
SECTION B: 5 NUMERICAL SOLUTION QUESTIONS
Question 6:
You are given the following variance – covariance matrix on two shares and the market portfolio. The risk-free rate is 6% per annum and the expected market return is 14% per annum. You have $500,000 available to invest. Assume that you are forming a portfolio by investing $200,000 in Share A, $200,000 in Share B and the balance of the $500,000 in risk free asset. What is the standard deviation of this portfolio in percentage terms?
[Type only thefinal answer into the response box below (NOT into the Notes box) and in pure numericformat. Do NOT use %/$ signs, commas or spaces (e.g. only enter 10 if it is 10 days/$10/10%)]
ANSWER: 17.98
Note: after investing $200,000 in Share A, $200,000 in Share B, the balance of the $500,000 is $100,000 (=500,000-200,000-200,000) invested in riskfree asset. Thus wA = 0.4, wB = 0.4, wRf = 0.2.
We are given Var(A) = 0.04, Var(B) = 0.09, Cov(A,B) = 0.036.
Thus, Var(P) =( 0.42 * 0.04) + (0.42 * 0.09) + (2 * 0.4 * 0.4 * 0.036), don’tforget to take the square root of the variance to get standard deviation, SD(P) = 17.98%
Further notes: 0.04 and 0.09 are VARIANCES meaning they are already squared standard deviations. Don’t square again! ( )2 is the same as 2 2 and here 2 is given to us as 0.04 (same reasoning for B)
Also make sure to pay attention to whether you are given correlation or covariance (here the latter) to plug in variance of portfolio formula: recall that × × , =
Portfolio Variance = = ( )2 + ( )2 + (2 × × × × × , )
Question 7
The Fast Reader Company supplies bulletin board services to numerous hotel chains nationwide. The owner of the firm is investigating the desirability of employing a billing firm to do her billing and collections. Because the billing firm specialises in these services, collection float will be reduced by 25 days. Average daily collections are $12,000 and the owner can earn 9% annually (expressed as an APR with monthly compounding) on her investments. If the billing firm charges $475 per month, what is the value today of the billing firm's charges?
[Type only thefinal answer into the response box below (NOT into the Notes box) and in pure numericformat. Do NOT use %/$ signs, commas or spaces (e.g. only enter 10 if it is 10 days/$10/10%)]
ANSWER: 63333.33
Amount available immediately = Average daily collections * Number of days collection float
is reduced = $12,000*25 = $300,000.
Assuming the billingfirm can reduce the collectionfloat immediately, as soon as Fast Reader
starts the service they will receive $300,000.
PV of billing firm's charges = billing firm's monthly charges/monthly discount rate, where monthly discount rate = APR/12 = 9%/12 = 0. 75%.
Thus, the present value of the billingfirm's charges is $475/0.0075 = $63,333.33
Note: the highlighted information above was not needed in this case. However, refer to post- lecture quiz 7 Q5 for possible alternative short answers that could have been asked in this scenario.
Question 8
Al Corporation plans to finance a new investment with leverage. It plans to borrow $56 million to finance the new investment. The firm will pay interest only on this loan each year, and it will maintain an outstanding balance of $56 million on the loan. After making the investment, the firm expects to earn annual free cash flows of $12 million. However, due to reduced sales and other financial distress costs, the firm's expected annual free cash flows will decline to $11 million. The firm currently has 5.7 million shares outstanding, and it has no other assets or
opportunities. Assume that the unlevered discount rate for the firm's future free cash flows is 8.9% and the firm's corporate tax rate is 30%. What is the firm's share price today?
[Type only thefinal answer into the response box below (NOT into the Notes box) and in pure numericformat. Do NOT use %/$ signs, commas or spaces (e.g. only enter 10 if it is 10 days/$10/10%)]
ANSWER: 14.81
Following MM2 Theory: VL = Vu + t*D where t =0.3, D =$56M, Vu = EBIT*(1-t)/ru = $11M/0.089=$123.60 (the firm's expected annual free cash flows or the firm's expected annual after-tax cash flows EBIT*(1-t) will decline to $11 million)
Also, VL = D+E = D +( P*N), where P is the share price, and N = 5.7M shares.
Thus,
P = [($11M/0.089) – $56M + 0.3*$56M]/5. 7M = $14.81 per share.
Question 9
An Australian firm is planning to make an investment in Europe. The firm estimates that the project will generate cash flows of 100,000 euros at the end of the year. If the one-year forward exchange rate is $1.50/euro and the dollar cost of capital is 8%, what is the present value (PV) of the project cash flows?
[Type only thefinal answer into the response box below (NOT into the Notes box) and in pure numericformat. Do NOT use %/$ signs, commas or spaces (e.g. only enter 10 if it is 10 days/$10/10%)]
ANSWER: 138889
Convert 100000 euros into dollar cash flows.
1 euro=1.50 dollars so 100000 euros=150000 dollars
Dollar cash flows can now be discounted by the dollar cost of capital (need to be consistent), so PV=150000/1.08=138889
Question 10
A firm expects a project to have the following incremental Income Statement (all values in
millions of dollars):
Fiscal year 2015 2016 2017
$56.70 $69.60 $61.80
Costs -34.8 -42.7 -37.9
Depreciation - 1.9 - 1.9 - 1.9
EBIT 20 25 22
The project’s incremental pro-forma balance sheet is expected to contain the following working capital items at the end of those fiscal years (all values in millions of dollars):
Assets Liabilities
Fiscal year 2015
Inventories $2.80
Accounts receivable 1.3
Accounts payable $2.00
Fiscal year 2016
Inventories 3.5 Accounts payable 2.5 Accounts receivable 1.6
Fiscal year 2017
Inventories 3.1 Accounts payable 2.2 Accounts receivable 1.4
In 2016, expected incremental capital expenditures total $2.9 million and incremental after tax salvage is expected to be $5.0 million. The tax rate for the project is 30%. What are the expected incremental cash flows in millions of dollars from the project in 2016?
[Type only thefinal answer into the response box below (NOT into the Notes box) and in pure numericformat. Do NOT use %/$ signs, commas or spaces (e.g. only enter 10 if it is 10 days/$10/10%)]
ANSWER: 21.00
Incremental cash flows = Incremental earnings - capital expenditures + depreciation + after tax salvage - change in net working capital
Incremental earnings = EBIT − taxes = 25.0 – (25.0 × 0.3) = 17.5m
Capital expenditures, depreciation, and after- tax salvage are given. So, all that remains is to compute the change in net working capital.
NWC = Accounts receivable + Inventories − Accounts payable.
2016 NWC is 2.6m and 2015 NWC is 2.1m.
So, the change in net working capital is 2.6-2.1 =0.5m.
Therefore, incremental cashflows = 17.5m -2.9m + 1.9m + 5.0m - 0.5m = $21 million dollars.
SECTION C: ESSAY QUESTIONS
Question 11
Answer the following questions:
a. What is the relationship between the covariance and the correlation coefficient?
b. You are a risk-averse investor who is considering investing in one of two economies. The expected return and volatility of all shares in both economies is the same. In the first economy, all shares move together—in good times all prices rise together and in bad times they all fall together. In the second economy, share returns are independent—one share increasing in price has no effect on the prices of other shares. Which economy would you choose to invest in? Explain.
c. Describe the impact on the SML of a 3% decrease in inflation.
d. Explain the differences between the classical dividend tax system and the imputation tax system. Clearly state how each taxes dividends and explain which of the two systems encourages larger dividend payouts.
Suggested answers:
a. The covariance between the returns of assets i andj is affected by the variability of these two asset returns. Therefore, it is difficult to interpret the covariance figures without considering the variability of each return series. In contrast, the correlation coefficient is obtained by standardising the covariance for the individual variability of the two return series, that is:
Correlation coefficient(i,j) = Covariance(i,j)/[SD(i)*SD(j)]
Thus, the correlation coefficient can only vary in the range of -1 to +1. A value of +1 would indicate a perfect linear positive relationship between the two asset returns.
b. A risk-averse investor would choose the economy in which share returns are independent because this risk can be diversified away in a large portfolio.
c. There will be a parallel shift down in the SML as illustrated below. The SML originates from the Rf point, any decrease in inflation would lead to a decrease by 3%, and it would cause the point of SML origin to go down shifting the entire line down. (Note: refer to Lecture 9 slide 42-you will not be required to draw a diagram in thefinal exam).
d. Under the classical system (such as what the US has) dividends are effectively taxed twice. Once at the company level (before payment of the dividend) and once at the individual level when an investor receives his dividend.
The imputation system involves a credit that is given to the investorfor the tax paid at the company level. As such dividends are not taxed twice. Since the imputation system involves paying less tax on dividends by the individual, it encourages larger dividend payouts.
Question 12
You are considering two identical firms one levered the other not. Both firms have expected EBIT of $600. The value of the unlevered firm (vU) is $2000. The corporate tax rate (t) is 30%. The cost of debt (rD) is 10%, and the ratio of debt to equity (D/E) is 1 for the levered firm. (a) Calculate the cost of equity for both the levered (rL) and unlevered firms (rU). (b) Calculate the weighted average cost of capital for each firm.
(c) Why is the cost of equity higher for the levered firm, but the WACC lower?
(d) In an MM world without taxes, what is the optimal capital structure?
(a) Calculate the cost of equityfor both the levered (rL) and unleveredfirms (rU). rU = EBIT(1-t)/vU = 600(1-0.30)/2000 = 21% rL = rU + (rU – rD)(1-t)(D/E) = 0.21 +
(0.21-0.10)(0. 70)(0.50/0.50) = 28. 70%
(b) Calculate the weighted average cost of capitalfor eachfirm.
The unleveredfirm’s WACC = 21%
The leveredfirm’s WACC = 0.10*(0. 7)*(0.5) + 0.287*(0.5) = 17.85% (c) Why is the cost of equity higherfor the leveredfirm, but the WACC lower? Equity holders bear more of thefinancial risk in the leveredfirm.
WACCfalls because debt is cheaper than equity andplus interest payments are tax deductible.
Gainsfrom use of debt are not completely offset by increase in cost of equity due to tax shield.
(d) In an MM world without taxes, what is the optimal capital structure? Capital structure is irrelevant in an MM world without taxes
Question 13
Floorstreet Stock Raiders Incorporated (FSR) has the following capital structure: Debt 25%, Preferred Stock 15%, Common Equity 60%. FSR’s beta is 1.5. FSR’s expected net income this year is $34,285.72, its established dividend payout ratio is 30 percent, its corporate tax rate is 40 percent, and investors expect earnings and dividends to grow at a constant rate of 9 percent in the future. FSR paid a dividend of $3.60 per share on its 76,000 issued ordinary shares. The Treasury note rate is 4.3% and the market risk premium is 8%. FSR can obtain new capital in the following ways:
+ Preferred: Issue 10,800 new preference shares committing FSR’s to a dividend of $11. The preference shares can be sold to the public at a price of $95 per share.
+ Debt: Issue 1,800 ten year $1,000 par value bonds to the public. The bonds will pay 11. 115% coupons (annually) and have a current yield to maturity of 12%. a. What is the firm’s cost of debt?
b. What is the firm’s cost of preferred equity?
c. What is the firm’s cost of ordinary equity?
d. What is the firm’s overall cost of capital?
e. The following investment opportunities have the same level of risk with FSR. Which projects should FSR accept? Why?
Suggested solution:
a. What is thefirm’s cost ofdebt?
Current YTM = Pretax cost of debt (rD) = 12%
Thefirm’s after-tax cost of debt = rD*(1-t) = 12% * (1-0.4) = 7.2%
b. What is thefirm’s cost ofpreferred equity? Thefirm’s cost ofpreferred equity = $11/$95 = 11.6%
c. What is thefirm’s cost ofordinary equity?
SML model: thefirm’s cost of ordinary equity = Risk-free rate + Beta * Market risk premium = 4.3% + 1.5*8% = 16.3%
d. What is thefirm’s overall cost ofcapital?
Given thefirm’s capital structure: Debt 25%, Preferred Equity 15%, Ordinary Equity 60% Thefirm’s WACC = 25%*7.2% + 15%*11.6% + 60%*16.3% = 13.32%.
e. Given the following investment opportunities. Which projects should FSR accept? Why? Given the same level of risk, FSR should accept A, B, C and D as all of them are affordable (no constraint provided) and provide a return greater than the cost offunds.
Question 14
Mick Ronalds is a fast-food establishment that is considering replacing its fryolators. The cost of the new plant is $200,000. For tax purposes, depreciation is allowed at 20% on prime cost (this means, straight line over the next five years). The plant would be sold for $40,000 at the end of its ten-year life.
Operating expenses will be $90,000 per annum, compared with $120,000 a year for the existing fryolators. However, if the existing plant were kept, $70,000 would need to be spent in four
years’ time on maintanance, which would be immediately expensed for tax purposes. The existing plant is being depreciated at $6,000 a year. It now has a book value of $60,000. This plant could be sold today for $50,000. Alternatively, it could be used for the next ten years and then scrapped for nil value.
The tax rate is 30%. Mick Ronald’s equity beta is 1.00, the pre-tax cost of debt is 20% and the risk free rate and market return are 6% and 14%, respectively. Mick Ronald’s debt to equity ratio is 1.
a. What is the firm’s overall cost of capital?
b. What is the firm’s initial investment?
c. What is the firm’s operating cash flow in year 1?
d. What is the firm’s operating cash flow in year 4?
e. What is the firm’s operating cash flow in year 6?
f. What is the firm’s terminal cash flow?
Suggested solution:
a. What is thefirm’s overall cost ofcapital?
SML model: Cost of equity = 0.06 + 1.00×(0.14-0.06) = 0.14
After tax cost of debt = 0.2*(1-0.3) = 0.14
D/E = 1 so D/(D+E) = 0.5, E/(D+E) = 0.5
WACC = 0.5*0.14 + 0.5*0.14 = 0.14
b. What is thefirm’s initial investment?
Given the capital lossfrom the sale of oldplant: 50,000-60,000 = -$10,000, the Tax Refund on
the sale of old plant = 30%*10,000 = +3,000 (note: tax payment if a capital gain is realised from the sale, e.g the tutorial question, and tax refund if there is a capital loss).
CF00 = - Cost of New Plant + Sale of existing Plant + Tax Refund on Sale of Old Plant = -200,000 + 50,000 + 3,000 = -$147,000
c. What is thefirm’s operating cashflow in year 1?
In the context of this question: Operating CFs = (Incremental Rev – Incremental OpEx – Incremental DA)*(1-tax rate) + Incremental DA, where
Incremental Rev = 0,
Operating expenses (OpEx) decrease from $120,000 to $90,000, implying cost savings of $30,000,
Incremental DA = DA of New plant – DA of Old plant
DA of New plant in years 1-5 = 200,000/5 = $40,000
DA of Oldplant is given as $6,000
Thus, Incremental DA is $34,000 in years 1-5, and is -$6,000 in years 6-10. Overhaul cost of $70,000 is spent on Old Plant in year 4 only.
CF1=CF2=CF3=CF5= (0+30,000-34,000)*(1-0.3)+34,000 = $31,200.
d. What is thefirm’s operating cashflow in year 4?
Overhaul cost of $70,000 spent on Old Plant in year 4 is a cost saving as this amount will not be spent if Old Plan is replaced. Thus, total cost savings in year 4 = 30,000 + 70,000 = $100,000
CF4= (0+100,000-34,000)*(1-0.3)+34,000 = $80,200.
e. What is thefirm’s operating cashflow in year 6?<
2022-06-13