MBAD 250 – Mid-Term Exam Spring, 2006 Questions, answers & Comments Below are the exam questions {with their point weight indicated at the beginning of a section, or in [ ] square brackets with each question – the points total to 100}. Be aware that the exam is integrative => relevant reasoning and concepts from more than one topic covered may be needed to fully answer a particular question {e.g., reasoning from risk may be needed to answer a question concerning valuation}. You may bring to the exam: 1. One sheet of paper with whatever notes you wish [I will put any equations or notation you request on the board during the exam]; 2. A calculator, though it is not required; and 3. A copy of the Causal Tree. For any question, if necessary, you may write brief phrases reflecting your reasoning or any assumptions you're making in your answer; so I know what you're thinking. For the fill-in-the-blank questions, you should be able to answer them in one word or a short phrase. For the computational questions, I require a computatioal trail of your reasoning in finding the answer {so if you get it numerically wrong but have the right reasoning, you'll still get considerable credit}. Short phrases about what you're assuming and why you're doing a particular calculation will help me understand your thought process in seeking the answer. The clearer the trail, the better the grade. For the essay questions, I require that you explain {provide a clear statement of the major elements needed to answer the question} and justify {provide the reasoning that common sensically backs up your "explain" statements} for a good answer. Just like your real-world boss, I'm asking specific questions in search of specific answers that would allow me to judge the validity of your answer. Technical jargon and reciting equations is worth little by itself. If you are not sure what a particular word or phrase means, ask me. If you need an equation, or a symbol defined, ask me. I’ll put it on the board for everyone. Put your answers on the exam itself. Write clearly, as I have no choice but to ignore whatever I cannot clearly read and understand. You’re as fully prepared as you can be, so relax and don’t let your fear and/or nervousness overcome your thought and reasoning; just like you would do in the real world. I hope you do well on this exam; we’ll both look good. Fill-in-the-blank questions {use a word or short phrase}: [Each question = 3 points, unless otherwise indicated. Total points are 39 of the 100 total exam points. The length of the blank says nothing about the length of the word/phrase.] 1. The two sources of the firm’s funds are __________________ and ________________. 2. The two sources of the firm’s equity funds are ______________ and _____________. 3. The three fundamental variables of Finance are ______________, _______________ and ______________. 4. The two variables that determine the RR required return are and ___________________. _________________
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5. The two variables that determine the ER expected return are ______________ and ____________________. 6. The two conditions that are enforced by a PV present value calculation are _____________________ and _____________________. 7. Free cash flow is determined by ___________________ minus ____________________. 8. If the firm’s ER is less than its RR, then its market/book ratio will be [greather than, equal to, less than] ___________________________ 1.0. 9. For an investment to add all of its risk to a portfolio, then its correlation with the other members must be _________________. 10. If the RRd market’s required return on the firm’s debt is equal to the coupon rate on the debt, then the firm’s bonds will sell at ____________________ relative to the bond’s face value, and the bond price will subsequently ________________ as the bond approaches its maturity date. 11. For Cash Inflows on a stock, the individual’s viewpoint has ________________, while the whole market’s viewpoint does not. However, the two viewpoints yield the exact same P0 current stock price because ___________________________________. 12. One of the two major risks of holding a firm’s bonds is ______________________. 13. For two borrowers who both have the same interest coverage ratio [normal {average} income divided by interest payments], the borrower with the higher ____________________ would be more likely to default on their debt. Computational Questions {SHOW your computational trail with your answer, &/or briefly explain your reasoning for full credit}: [Six points/question => total points are 30.] 14. Given the cash flow stream that has an immediate cash outflow of 500, then cash inflows of 60 at the end of each of the next 5 years, and finally has a cash inflow of 500 at the end of the fifth year, a. Draw a time line of the above cash flow stream
b.
What would be the NPV of the cash flow stream at an RR = 0?
c.
What RR required return would produce a NPV = 0?
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15. An investor pays $50 today for a share of stock, and expects that the firm will pay no dividends for the next four years. A $1 dividend is currently expected at the end of the fifth year, which dividend is expected to grow at 10% per year for the far future after that. Today’s investor expects to sell the stock at the end of the eighth year for $72.50. Draw a time line of today’s investor’s expected cash flow stream. [All cash flows are at the end of each year, two significant digits are all that’s needed for the time line.]
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16. Using the information in question 15, if the current investor expects dividends at the end of year 9 to be $1.45, what RR required return is the current investor assuming for the stock when it’s sold at the end of the 8 th year? [Note: If the answer to any prior question is wrong, you’ll still get credit if your process and reasoning are right.]
17. Given your answer to question 16, what would be the expected end-of-year 8 b[St] beta for the firm’s stock if RRm the market return = .11 and RRf the riskless rate = .05?
18. Given V[St] the cap market value of the firm’s stock = 1200, and V[Debt] the market value of the firm’s debt = 800, and T the firm’s income tax rate = .4 and the RR[St] required return on the stock = .10, and finally the ER[Co] expected return of the company [business, operations] on a new investment = .075: What maximum before-tax RRd return required on the firm’s debt can the firm afford to pay to make the investment worthwhile [i.e., have a NPV greater than zero]?
Essay Questions [31 points total, write your answers on the attached blank sheets. You do not need anywhere near a full sheet to answer each question.]: 19. [10 pts] What does it mean when a stock is selling at a “premium”? In terms specific to this course [vs. vague generalizations like “good management”, ...], what fundamental condition[s] must exist to justify the premium? Explain & justify your answer. 20. [10 pts] From an investor’s viewpoint, why are stocks riskier to hold than bonds? Explain & justify. 21. [11 pts] While Finance uses the accounting model, the focus of Finance differs from accounting in two major ways: The time period and valuation. Explain these two differences in the focus of each discipline.
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Answers & Comments: Fill in the blanks: 1. 2. 3. 4. 5. 6. Debt and equity, via the basic accounting model. Some said “sales”, but all expenses must be paid. Others said “profit”, but the firm may pay all profits out in dividends. Retained earnings, common stock, again via the accounting model. Most got this. Profit, investment, risk. Most got this. Riskless rate, risk premium. Opportunity cost is just another name for RR. Profit, investment. Most got this. Recoup cost, earn the return required. Some said “time value of money”, but that’s overly general and definitional; others said “the investment horizon”, but that’s only a part of the cash flow stream that the PV calc enforces the two requirements on. Profit, investment. Some said “sales” or “expenses” [which lead to profit, but ignores the investment variable] or were overly general with “cash inflows” [borrowing produces a cash inflow, but is not part of free cash flow]. Less than. If the firm can’t earn sufficient profit to recoup the investment’s cost and provide ER = RR, then the investment’s market value must be less than its cost [as enforced by the PV calc in #6 above]. Correlation = +1.0, which reflects that the investment’s variations are never offset by other members. Some said corr <1.0 or zero or not -1.0, but in all of those cases, some of the investment’s volatility would be offset. Par or Face, stay the same. Many got this. Those that didn’t seemed to assume the bond couldn’t sell at par, and got only partial credit. Sell the stock or capital gain/loss, future stock price is PV of expected dividends after that point in time. Some gave overly general answers like “market conditions”, “firm’s performance” or “risk”, but these all apply both to the individual and the whole market. Interest rate or default or call risk. Any one is fine [tho we didnt’ cover call risk, but it’s in the book]. Most got this. SD[income] or predictability of income. Less stable income means that the borrower is less likely to be able to pay interest in a “bad” year. Some said “interest”, but that’s part of the interest coverage calculation; others said “amount of debt” or “debt ratio”, but that’s imbedded in the interest coverage ratio via the interest in the denominator.
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8. 9.
10. 11.
12. 13.
Computational Questions: 14. a: t Time line: 0 1 2 3 4 5 |------|------|-------|-------|-------| $ -500 60 60 60 60 60+500 The most common problem is that somw left the final 60 off of year 5. Some others put the 500 cash inflow in year 6. b: With an RR=0, there’s zero time value of money => all future cash flows have their full PV => NPV = 60*5 = 300. The -500 & +500 just offset. The most common mistake was to ignore the initial -500 cash outflow, and give NPV = 800.
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c: Given that NPV = 0, then the RR must equal ER, and ER = 60/500 since the 500 inflow in year 5 recoups the initial -500 investment. Therefore, ER = .12 = RR. Many tried it the hard way: Solving the NPV equation for RR. If it was set up well, I gave virtually full credit. 15. Time line: t 0 1 2 3 4 5 6 7 8 |-----|------|-------|-------|-------|-------|-------|-------| $ -50 0 0 0 0 1.0 1.10 1.21 1.33+72.50 The most common error was to ignore the P[8] = 72.50 selling price expected. A few used growth rates other than 10%, for reasons I don’t understand; and a few others ignored the 50 cost at year 0. Use the Gordon model with P[8] and 1.45 Div[9] & g{Div}=.10 given: 72.50 = 1.45/[RR - .10] and solve for RR = .12 Some tried using Gordon with P[0] of 50, but that’s no good since there are no dividends for 4 years and Gordon requires constant growth rate. Others calculated the growth rate of Div’s from year 8 to 9, and said that was the RR, but it’s a one-year growth rate of Div’s, not RR. Using the CAPM: .12 = .05 + [.11 - .05] * beta => beta=[.12-.05]/.06 = 1.17 If the wrong RR=.12 from question 16 was used but the approach was right, I gave full credit. Some tried the long NPV equation, and if they set it up correctly, I gave virtual full credit. If the NPV of the investment is to be zero, then RR[co] = ER[co]=.075 given. Using WACC: RR[co]=.075 = {800/[800+1200]}*RRd*[1-T] + [1200/2000]*.10 Solving for RRd = [.075-.06]/[.4 * .6] = .0625 = max interest rate the firm can pay on its debt to make RR[co] = .075 = ER[co] => NPV = 0. More than a few people didn’t even use the WACC approach, which is the only resonable way to address the question. Some [creatively] attempted to use and income statement approach with a company-level valuation model, and I gave considerable credit for the creativity. A few didn’t even try. Some using WACC, instead of using the V[co]=800debt + 1200equity market values, used unreasonable or [seemingly] arbitrary company market values.
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Essay Questions: 19. A stock sells at a premium when its market value is greater than its accounting book value, indicating that the firm is worth more in the market than the money that the firm has that belongs to its owners. This can happen only when ER > RR the firm is expected to earn a return greater than is required by its owners; and the premium is the NPV > 0 of those excess returns. Most got what the premium is; though some said its was when the stock price was inflated or greater than that predicted by the Gordon model, neither of which is correct. Many did not address the 2nd part of the question: The fundamental condition that must exist is ER > RR. Some cited vague reasons like inflation, the economy, ... . The main reason that stocks are riskier than bonds is because the owners are last in line for the firm’s profits and its assets in bankruptcy, whereas the lenders take priority over owners. Hence, the lenders can be more assured of their cash inflows from interest and principal, vs. the owners have to guarantee of receiving dividends.
20.
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Many got this. Those who had weaker answers simply said that the cash inflows to owners are less certain than for lenders, without saying why that’s the case. Others cited generalities about systematic risk or inflation, without getting to the meat of the question. 21. Accounting reflects what the firm has done in the past, in terms of profits and investment/financing. As such, the values carried on the firm’s accounting statements are historical cost or book values; which have nothing to do with what the firm is worth today. Finance, in contrast, deals with the current market value of the firm, which current market value is the PV of currently expected future cash flows from the firm to its investors. Most got this. Somewhat weaker answers used generalities rather than being explicit and clear: Saying “book value” without making clear that its historical cost that has nothing to do with current market value; saying current market value without making clear that its based on current expectations of the firm’s future performance; ... . Computational 23.8 24.5 24.1 Essay 28 27.3 27.6 Total 82.8 82.5 82.6 9.1 9.4 9.1
Midterm Exam Results: # Fill-in-blanks StdDev Tuesday 29 31.1 Thursday Overall 31 60 30.7 30.9
The results are above average for a midterm [it’s usually around the upper 70’s], and I don’t feel the exam was easier than ones in the past; so that’s good. The average grades by section are virtually identical in all areas, which comparability is the advantage of giving the same exam to both sections: Neither section has a harder exam. If I had to assign letter grades right now, the A’s would go down to about 90 [25% of the class of 60], and the B’s would cut off around the low-mid 70’s [about 2/3’s of the class]; meaning the remaining roughly 12% are in danger of a C. Bear in mind that the above is just for your rough information – the final grades will be based on the final rank. If your grade is near a cutoff, your final grade could go either way.
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