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Name: ________________________________________ I.D. #: _______________________ St. Francis Xavier University Department of Business Administration BSAD 341 – Introductory Financial Management Final Examination • December 14, 2006 Dr. Shantanu Dutta 2½ hours Dr. Timothy Hynes Part I • Multiple Choice (30 marks). Choose the one alternative that best completes the statement or answers the question. Answer on the card provided. 1. The rate of return earned on an investment of $50,000 today that guarantees an annuity of $10,489 for six years is approximately. A) 7%. B) 30%. C) 5%. D) none of the above 2. The conservative financing strategy results in financing all projected funds requirements with __________ funds and use of __________ funds in the event of an unexpected cash outflow. A) long-term; short-term B) seasonal; permanent C) permanent; seasonal D) short-term; long-term 3. The legal contract setting forth the terms and provisions of a corporate bond is A) an indenture. B) a promissory note. C) a debenture. D) a loan document. 4. The relevant portion of an asset's risk attributable to market factors that affect all firms is called A) systematic risk. B) diversifiable risk. C) unsystematic risk. D) none of the above. 5. The __________ measures the dispersion around the expected value. A) mean B) standard deviation C) chi square D) coefficient of variation 6. An increase in nondiversifiable risk A) would cause an increase in the beta and would lower the required return. B) would cause an increase in the beta and would increase the required return. C) would have no effect on the beta and would, therefore, cause no change in the required return. D) would cause a decrease in the beta and would, therefore, lower the required rate of return. 7. Each of the following are measures of risk EXCEPT A) the stock's variance and standard deviation. B) the stock's range in expected returns under different economic conditions. C) the stock's beta. D) all of the above are measures of risk 8. Asset P has a beta of 0.9. The risk-free rate of return is 8 percent, while the return on the market portfolio of assets is 14 percent. The asset's required rate of return is A) 10 percent. B) 5.4 percent. C) 6.0 percent. D) 13.4 percent. 9 For bonds with the same time to maturity, __________ bonds have the lowest yield to maturity. A) Saskatchewan Wheat Pool B) Royal Bank C) Air Canada D) Government of Canada 10. An upward-sloping yield curve that indicates generally cheaper short-term borrowing costs than long-term borrowing costs is called A) a flat yield curve. B) an inverted yield curve. C) a normal yield curve. D) none of the above. 11. If the required return is less than the coupon rate, a bond will sell at A) a premium. B) par. C) book value. D) a discount. 12. The __________ is/are a graphic depiction of the term structure of interest rates. A) yield curve B) aggregate demand curve C) risk-return profile D) supply and demand functions 13. The firm's optimal mix of debt and equity is called its A) optimal ratio. B) maximum book value. C) target capital structure. D) maximum wealth. BSAD 341 • Final Examination, December 14, 2006 Page 2 14. An increase in the average payment period will result in __________ in the cash conversion cycle A) a decrease B) an undetermined change C) an increase D) no change 15. A firm is evaluating a proposal which has an initial investment of $50,000 and has cash flows of $15,000 per year for five years. The payback period of the project is A) 1.5 years. B) 4 years. C) 2 years. D) 3.3 years. 16. Relevant cash flows for a project are best described as A) incidental cash flows. B) sunk cash flows. C) accounting cash flows. D) incremental cash flows. 17. An increase in accounts receivable turnover due to an increase in collection efforts will A) increase the firm's marginal investments in accounts receivable. B) decrease the firm's collection expense. C) increase the firm's bad debt expense. D) decrease the firm's marginal investments in accounts receivable. 18. The __________ feature permits the issuer to repurchase bonds at a stated price prior to maturity. A) put B) call C) conversion D) capitalization 19. Another name for a bond that does not make periodic coupon payments is a A) zero coupon bond. B) subordinated debenture. C) floating rate bond. D) junk bond. 20. Perfectly __________ correlated series move exactly together and have a correlation coefficient of __________, while perfectly __________correlated series move exactly in opposite directions and have a correlation coefficient of __________. A) negatively; + 1; positively; -1 B) negatively; -1; positively; +1 C) positively; -1; negatively; +1 D) positively; + 1; negatively; -1 21. When the required return is constant but different from the coupon rate, the price of a bond as it approaches its maturity date will A) remain constant. B) decrease. C) approach par. D) increase. 22. __________ is the actual amount each common stockholder would expect to receive if the firm's assets are sold, creditors and preferred stockholders are repaid, and any remaining money is divided among the common stockholders. A) Liquidation value B) Book value C) The present value of the dividends D) The PIE multiple 23. Generally, an increase in risk will result in _________ required return or interest rate. A) a lower B) an unchanged C) a higher D) an undetermined 24. A firm has determined its cost of each source of capital and optimal capital structure, which is composed of the following sources and target market value proportions: Target market Source of capital proportions After-tax cost Long-term debt 45% 5% Preferred stock 10 14 Common stock equity 45 22 If the firm were to shift toward a more leveraged capital structure (i.e., a greater percentage of debt in the capital structure), the weighted average cost of capital would A) decrease. B) increase. C) remain unchanged. D) not be able to be determined. 25. __________ risk represents the portion of an asset's risk that can be eliminated by combining assets with less than perfect positive correlation. A) Diversifiable B) Nondiversifiable C) Total D) Systematic 26. __________ of all future cash flows an asset is expected to provide over a relevant time period is the value of the asset. A) The present value B) The future value C) The sum D) The stated value BSAD 341 • Final Examination, December 14, 2006 Page 3 27. Sophisticated capital budgeting techniques do not A) explicitly consider the time value of money. B) use net profits as a measure of return. C) take into account an unconventional cash flow pattern. D) examine the size of the initial outlay. 28. If the annual rate of return on a common stock is normally distributed with a mean of 12% and a standard deviation of 10%, what is the range that has a 95% probability of covering the expected return? A) 2% to 22% B) 0.6% to 23.4% C) -8% to 32% D) 10.8% to 13.2% 29. The cost of common stock equity is A) the rate at which investors discount the expected dividends of the firm. B) the aftertax cost of the interest obligations. C) the historical cost of floating the stock issue. D) the cost of the guaranteed stated dividend. 30. The beta of the market A) is greater than 1. B) is 1. C) is less than 1. D) cannot be determined. BSAD 341 • Final Examination, December 14, 2006 Page 4 Part II • Problems (45marks) Do all questions in the space provided. (6) 1. Tom Cruise has received a settlement from an insurance company that will pay him $40,000 annually for 5 years. Current interest rates are 8 percent, compounded quarterly. a) What is effective annual interest rate? b) How much is the present worth of Tom’s settlement? (Assume the payments are made at the end of each period.) c) How much is the present worth of Tom’s settlement if the payments are made at the beginning of each year? (4) 2. You deposit $4,000 today. It grows for six years at 10% interest compounded semi-annually. You then withdraw the funds annually over the next 4 years. The annual interest rate over that four year period is 8%. What is the dollar amount of the annual withdrawal? BSAD 341 • Final Examination, December 14, 2006 Page 5 (12) 3. Leon Corporation has issued 400 bonds with a face value of $1,000, interest paid semi-annually of 8%, and a maturity of 11 years. Yield to maturity on the bonds is 10%. The income tax rate is 40%. The firm’s beta (of common equity) is 1.5. The risk free interest rate and the market risk premium are 4.5% and 7% respectively. There are 10,000 common shares outstanding with a dividend growth rate of 8% per year and the company paid a dividend of $5 per share last year. The firm has 300 preferred shares outstanding with a face value of $1,000 and dividend rate of 6% (based on face value) and the before-tax cost of preferred shares is 10%. (a) What would each of Leon’s $1000 face value bonds sell for on the open market? (b) What would be the total market value of the company’s bonds? (c) What would the Capital Asset Pricing Model suggest is the required return for Leon Corporation’s common stock? NOT COVERED in 2008 (d) What would be the market price of the company’s common shares? (e) What would be the total market value of the company’s outstanding common shares? (f) How much should the company’s preferred shares sell for in the market place? (g) Using the information you have calculated above, determine Leon Corporation’s weighted average cost of capital. NOT COVERED in 2008 BSAD 341 • Final Examination, December 14, 2006 Page 6 (6) 4. Newman Manufacturing is considering a takeover of Grafton Tool. During the year just completed, Grafton earned $4.25 per share and paid cash dividends of $2.55 per share. Grafton’s earnings and dividends are expected to grow at 25 percent per year for the next 2 years, and in the third year the expected dividend payment is $4.5 per share. Thereafter the dividends are expected to grow at 10 percent per year to infinity. What is the maximum price per common share Newman should pay for Grafton if it has a required return of 15 percent on investments with risk characteristics similar to those of Grafton? (6) 5. Ajax corporation recently purchased a new asset for $400,000. For tax purposes the asset gets added to the company’s Class 8 CCA Tax Pool. These assets are depreciated at a CCA rate of 20% per year. Ajax’s tax rate is 26%. (a) Calculate the amount of the CCA Ajax could claim for the first three years of the asset’s life. (b) How much tax savings would the company receive each year (for years 1 to 3) as a result of the purchase? (c) What would be the total present value of the “tax shield” associated with the asset acquisition? BSAD 341 • Final Examination, December 14, 2006 Page 7 (11) 6. An officer for a large construction company is feeling nervous. The anxiety is caused by a new excavator just released onto the market. The new excavator makes the one purchased by the company a year ago obsolete. As a result, the market value for the company’s excavator has dropped significantly, from $100,000 a year ago to $35,000 now. In 10 years, it is estimated that it would be worth $5,000. The new excavator costs only $775,000 and would increase operating revenues by $65,000 annually. The new equipment has a 10-year life and expected salvage value of $100,000. If the company decides to buy the new equipment, Net Working Capital (NWC) would increase by $5,000 initially. The tax rate is 40%, the CCA rate is 25% for both excavators, and the required rate of return for the company is 14%. Required: Conduct a Net Present Value Analysis and state what recommendation the officer should make. BSAD 341 • Final Examination, December 14, 2006 Page 8 Part III • Short Answer Questions (25 marks) Do any five (5) of the following six questions. 1. What are the frequently cited theories to explain the general shape of the yield curve? Briefly describe any one of those theories. NOT COVERED in 2008 2. Target Corporation is considering an investment opportunity that has been determined to have an Internal Rate of Return (IRR) of 17%. Its net present value at a zero percent discount rate is +$240,000. Draw the NPV profile for this investment opportunity on the graph below. Be sure to label the axis and points of intersection on the graph clearly. 3 Outline the key differences among debt, preferred and common equity capital in light of the following characteristics: (i) voice in management; (ii) claims on assets, (iii) tax treatment. BSAD 341 • Final Examination, December 14, 2006 Page 9 4. What is the difference between aggressive and conservative funding strategies for seasonal financing requirements? What is the relationship between cost and risk for these strategies? NOT COVERED in 2008 5. What is the cash conversion cycle? What are the tactics/strategies companies can employ to minimize and manage the cash-conversion cycle? NOT COVERED in 2008 6. Discuss how the prices of bonds are affected by (i) changes in risk and (ii) differences in time to maturity.