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COMM308 Final Exam – Winter 2000 SECTION I Questions 1-5 are worth 1 mark each Answer TRUE or FALSE and fill in the appropriate blank A) or B) ON THE COMPUTER ANSWER SHEET 1) You have just won a $1 million lottery prize. You can choose to receive $1 million today a)T b)F or an annual payment of $50,000 at the end of each of the next twenty years. As long as market interest rates are greater than zero, you should take the lump sum 2) If one uses the constant dividend growth model to value a stock, one assumes that a)T b)F P0 = P1 = P2 = ... = P 3) All else equal, a higher corporate tax rate decreases the tax savings from a terminal loss a)T b)F 4) On some days, you notice that stock prices fluctuate wildly. This implies that markets a)T b)F are inefficient 5) Stock price volatility is beneficial to option holders a)T b)F SECTION II Questions 6-17 are worth 1 mark each Indicate your answer by filling in the appropriate letter on the computer answer sheet. 6) Which of the following is FALSE? a) When comparing investments it is best not to rely solely on quoted rates b) Compounding will lead to differences between the quoted rate and the effective rate c) The annual percentage rate (APR) on a loan requiring monthly payments is the interest rate you actually pay d) An APR is the interest rate per period multiplied by the number of periods per year e) An ordinary annuity is a series of equal payments made at regular intervals of time 7) The present value of a set of cash flows is: a) the sum of the present value of the individual cash flows b) the sum of individual cash flows which are then discounted c) not equal to the sum of the present value of the individual cash flows d) always greater than the present value of the investment e) none of the above 8) The recovery of an additional investment in working capital is typically assumed to occur: a) at the beginning of the project's life b) evenly during the life of the project c) at the end of the project's life d) only if the project is sold before the end of its expected life e) only if there is a CCA recapture NPV vs Discount Rate 800 A Net Present Value 600 400 B 200 0 0 5 10 15 20 Discount Rate % 9) Projects A and B are mutually exclusive and have the same lives and initial cash outflows. For both projects, all cash flows beyond the initial one are positive. The two NPV profiles are given above. Consider the following three statements: i) There is no apparent conflict between NPV and IRR at any given opportunity cost of capital ii) Project B has a higher IRR than Project A iii) Both the NPV and the IRR will select the same project at an opportunity cost of capital of 10% Which of the above statements is(are) correct? a) i), ii) and iii) b) ii) only c) ii) and iii) d) i) and iii) e) None of the above statements is correct 10) Which of the following statements is FALSE? a) The NPV will be positive if the IRR is less than the cost of capital b) If the multiple IRR problem does not exist, any independent project acceptable by the NPV method will also be acceptable by the IRR method c) When IRR = r (the cost of capital), NPV=0 d) The IRR can be positive even if the NPV is negative e) The NPV method is not affected by the multiple IRR problem 11) Systematic risk is considered important because . a) it is needed in order to measure the total risk of an asset b) the risk premium depends only on this type of risk c) the market does not provide a reward for this type of risk d) the risk premium depends on both systematic and unsystematic risk e) investors are willing to pay more for stocks with high systematic risk components 12) The yield to maturity is: a) the rate that equates the price of the bond with the discounted cashflows b) the expected rate to be earned if the bond is held to maturity c) the rate that is used to determine the market price of the bond d) equal to the current yield for bonds priced at par e) all of the above 13) A stock's beta measures the: a) average return on the stock b) variability in the stock's returns compared to that of the market portfolio c) difference between the return on the stock and return on the market portfolio d) stock's unsystematic risk e) market risk premium on the stock 14) According to MM II, as a firm's debt-to-equity ratio decreases: a) its financial risk increases b) its operating risk increases c) the required rate of return on debt increases d) the required rate of return on equity decreases e) the required rate of return on equity increases 15) When choosing a capital structure, the objective of the firm should be to a) choose the one that maximizes the current value of the firm's bonds b) choose the one that minimizes the value of the firm c) choose the one that minimizes the firm's WACC d) choose the one that results in the largest interest tax shield e) choose any capital structure since capital structure is always irrelevant 16) Which of the following is true for an investor that has purchased an out-of-the-money put option on shares of common stock? a) The investor's maximum loss is the price of the option premium b) The investor must profit when the stock decreases in value c) The investor cannot earn a profit as long as the option is alive d) The investor is protected against upside potential e) Any increase in stock value goes to the seller of the put 17) Which of the following types of announcements is most likely to cause a DECREASE in the price of a stock? a) A repurchase of the firm's stock b) A stock split c) A decrease in the regular quarterly dividend d) An increase in the regular quarterly dividend e) Borrowing funds in order to pay a cash dividend SECTION III Questions 18-39 are worth 1½ marks each Indicate your answer by filling in the appropriate letter on the computer answer sheet. 18) You have $800 in a savings account which earns 6% interest compounded annually. How much additional interest would you earn in 2 years if you moved the $800 to an account which earns 6% compounded quarterly? a) $2.31 b) $5.19 c) $96.00 d) $98.88 e) $101.19 19) Given the following cash flows, what is the interest rate if the future value at the end of year 3 is equal to $2,393? Yr. 1 = $500; Yr. 2 = $750; Yr. 3 = $1,000 a) 6.5% b) 6.8% c) 7.0% d) 8.0% e) 8.9% 20) Bond A Bond B Face Value $1,000 $1,000 Semiannual Coupon 50 70 Years to Maturity 10 10 Price 885.30 ??? If these bonds are identical except for coupons and prices, what is the price of Bond B? If you are using the yield to maturity approximation, round your estimate to the nearest whole % before computing the bond price. a) $ 802.89 b) $ 999.22 c) $1,000.00 d) $1,023.11 e) $1,114.70 21) A firm expects to pay dividends at the end of each of the next four years of $2.00, $1.50, $2.50, and $3.50. Starting in year 5, dividend growth is expected to remain constant at 8%. If you require a 14% rate of return, how much should you be willing to pay for this stock? a) $67.81 b) $43.97 c) $58.15 d) $31.00 e) $22.49 22) The capital budgeting director of a company is evaluating a project which costs $200,000, is expected to last for 10 years and produce after-tax cash flows of $44,503 per year. If the firm's cost of capital is 14%, what is the project's IRR? a) 8% b) 14% c) 18% d) -5% e) 12% 23) Your company just bought a new piece of equipment for $60,000. This equipment is subject to a 20% CCA deduction. What is the undepreciated capital cost (UCC) of the equipment at the end of year 2? Incorporate the half-year rule. a) $ 8,892 b) $13,338 c) $19,998 d) $43,200 e) $54,000 24) What is the proportion of debt financing for a firm that expects a 20% required return on equity, and a 10% required return on debt if the required return on equity for a similar unlevered firm is 14%? Ignore taxes. a) 60% b) 50% c) 40% d) 30% e) 15% 25) You are the capital budgeting director of a fabric weaving company and are looking to replace an automated loom system. The old system was purchased 5 years ago for $200,000. The CCA rate is 20%. The firm has other assets in the same class, a 12% opportunity cost of capital and a marginal tax rate of 40%. The old system has 5 years of life remaining at which time it will have a $40,000 resale value. The current market value of the old system is $100,000. The new system has a price of $300,000, plus $50,000 in installation costs. The new system has a 5-year economic life, a $100,000 resale value, and by the end of year 1 will require a $40,000 increase in the spare parts inventory. This increase will be partially offset by an increase of $25,000 in accounts payable at the end of year 1. The new system will decrease operating costs by $40,000 per year. What is the present value of any changes in net working capital? Assume that any increase in working capital is reversed at the end of the project. a) -$4,881 b) -$6,489 c) $0 d) $4,881 e) $6,489 26) You are evaluating a project to add a new product to your company's line. The sales price per unit is expected to be $400. In year one, sales are projected at 1,000 units while in year two, the company expects to sell 1,500 units. Variable costs amount to $225 per unit and fixed costs are $125,000 per year. The project requires an initial investment of $105,000 which is depreciated straight-line over the three year life of the project. The company's marginal tax rate is 34% and the project's required return is determined to be 15%. What is the operating cash flow for the project in year 2? a) $26,400 b) $41,600 c) $61,400 d) $75,000 e) $102,650 27) XYZ Corp. has 1,000 shares outstanding and retained earnings of $25,000. Theoretically, what would you expect to happen to the price of their stock, currently selling for $50 per share, if a 20% stock dividend is paid? a) Price should increase to $55 per share b) Price should increase to $60 per share c) Price should decrease to $40 per share d) Price should decrease to $41.67 per share e) Nothing; price should remain at $50 per share 28) You have the following information on two stocks: Probability Stock A Return Stock B Return 0.1 -20% 10% 0.8 20% 15% 0.1 40% 20% The expected return for stock A is 18%, the expected return for stock B is 15% and the correlation between returns for the two stocks is 0.96. If you form an equally weighted portfolio of the two stocks, what is the portfolio's standard deviation? a) 8.1% b) 10.5% c) 13.4% d) 16.5% e) 20.0% 29) Suppose you purchased 100 shares of stock at a price of $45.00 per share. One year later you sell your shares when the price per share hits $55.00. During the investment period you also received a dividend per share of $4.00. What was your total dollar return from the investment? a) $300 b) $400 c) $1,000 d) $1,400 e) $5,500 30) What is the beta of a portfolio made up of the following two assets and the risk-free asset? Asset Portfolio Weight Beta Expected Return A 20% 2.25 20% B 20% 1.25 15% Risk-free 60% ??? 10% a) 0.450 b) 0.700 c) 1.167 d) 1.750 e) 2.000 31) What happens to expected return if beta increases from 1.0 to 2.0, the risk-free rate decreases from 5% to 4%, and the market risk premium remains at 8%? a) It increases from 12% to 19% b) It decreases from 19% to 12% c) It increases from 13% to 20% d) It decreases from 20% to 13% e) It does not change 32) Vintage Auto Inc., a manufacturer of classic automobiles, needs to raise $3 million via a rights offering. The subscription price is $20 per share. The firm currently has 300,000 shares outstanding and the current market price per share is $30. What do you expect to be the ex- rights price of the firm's stock? a) $ 3.33 b) $ 5.67 c) $ 10.00 d) $ 18.33 e) $ 26.67 33) Given the following information, what is XYZ Corp.'s weighted average cost of capital? Debt-to-equity ratio of 1.33; cost of equity = 20%; before tax cost of debt = 9%; equity beta =1.25; tax rate=35%. a) 11.9% b) 13.0% c) 13.7% d) 15.3% e) 15.9% 34) An unlevered firm has an EBIT of $250,000, net income after tax of $165,000, and a cost of capital of 12%. A levered firm with the same assets and operations has $1.25 million in debt, face and market value, paying an 8% annual coupon. What is the value of the levered firm? The tax rate is 34%. a) $1,250,000 b) $1,375,000 c) $1,667,667 d) $1,800,000 e) $2,625,000 35) A company has expected EBIT of $9,250 and debt with a face and market value of $14,000 paying a 9% annual coupon. The market value of the firm is $58,525. If the tax rate is 34%, what is the firm's unlevered cost of capital? a) 9.00% b) 11.35% c) 12.12% d) 12.76% e) 12.99% Use the following information to answer the next two questions. Assume a tax rate of 40%. Current Capital Structure Proposed Capital Structure Assets: $15 million $15 million Debt: $0 $ 3 million Preferred: $0 $ 3 million Equity: $15 million $ 9 million Common Share Price: $25.00 $ 22.50 Shares Outstanding: 600,000 ??? Bond Yield: --- 8% Coupon Rate: --- 8% Preferred Dividend Yield: --- 10% 36) Given that earnings before interest and taxes (EBIT) = $2 million, what is the EPS under the current capital structure? a) $7.50 b) $5.25 c) $4.00 d) $3.33 e) $2.00 37) What is the breakeven EBIT for these two capital structures a) $2,220,000 b) $1,800,000 c) $1,500,000 d) $720,000 e) More information is needed 38) Suppose that you purchase 6 European put option contracts with an exercise price of $45, where the market price of the puts are quoted at $9.12. The current price per share of the underlying stock is $52. Recall that one option contract calls for the sale or purchase of 100 shares of stock. What is your profit (loss) on the put options investment if at maturity the stock is trading at $40. a) $1,728 b) $2,472 c) $0 d) ($2,472) e) ($5,472) 39) A firm has stock outstanding with a current price of $12 per share. The price in one period is expected to be either $10 or $13. A call option on one share is available with an exercise price of $12. If the risk-free rate of interest is 12%, what would you expect to pay for the call option? a) $0.95 b) $1.00 c) $1.02 d) $2.21 e) $9.21 Solutions 1.a 11.b 21.b 31.c 2.b 12.e 22.c 32.e 3.b 13.b 23.d 33.a 4.b 14.d 24.a 34.d 5.a 15.c 25.a 35.b 6.c 16.a 26.e 36.e 7.a 17.c 27.d 37.a 8.c 18.a 28.a 38.d 9.b 19.d 29.d 39.c 10.a 20.e 30.b