FINAL EXAM key 2039 winter 2004

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					                                  LAKEHEAD                           UNIVERSITY
                                            Business 2039 WA/WB - Finance II
                                        FINAL EXAMINATION - MARKING KEY

K. Hartviksen                                                                                                        April 21, 2004


         1.     Check your copy of this test to ensure that it is complete.
         2.     This examination is 3.0 hours in duration. Note the relative value of the questions asked and judge your use of
                the available time accordingly.
         3.     You are allowed to bring to this test sufficient writing instruments to complete your work. For example, a ruler
                and a silent hand-held calculator. This is NOT an open-book quiz. You are allowed to bring to the test one
                8.5 inch by 11 inch crib sheet (both sides) for formulae ONLY. You must hand-in your crib sheet along
                with all of your completed work at the end of the test.
         4.     You are NOT allowed to take your copy of the examination paper from the examination room.
         6.     Place your name on this test paper before you begin your work.
         7.     Place your answers to the questions in the examination booklets provided.
         8.     When providing your solution to numerical problems, be sure to show all of your work so that part marks may
                be assigned.
         9.     Be sure to put your name on all documents and hand them all in at the end of the test.
         10.    Good Luck.


(5)    1.      Explain the meaning of the following terms as they are used in this course:
                        Market capitalization – refers to the total equity value of a firm at a given point in time. It is
                           measured by determining the product of the current market price per share and the number of
                           shares outstanding.
                        Accounting insolvency – is an act of bankruptcy and occurs when the value of liabilities exceed the
                           value of assets on the firms balance sheet.
                        Spontaneous liability – current liabilities such as accounts payable and accruals whose daily
                           balance rise and fall in response to the volume of business activity without further negotiation.
                        Pecking Order – a hierarchy of financing beginning with reinvested profits followed by debt
                           financing and finally external equity financing.
                        Vulture Funds – investment firms that specialize in corporate insolvency situations. These firms by
                           up creditor claims for a few cents on the dollar, and then use their expertise in the courts to ensure
                           that in the bankruptcy or reorganization process that they earn a greater amount per dollar of
                           creditor claim, thereby earning high return on their invested capital.

      Business 2039 Winter 2004 – FINAL EXAMINATION                                                                      Page 1
(10) 2.    Assume that the risk-free rate, RF, is currently 9 percent and that the market return, km, is currently 13 percent.
                 a. Draw and label the security market line (SML).
                 b. Calculate and label the market risk premium on the axes in a.
                 c. Given the previous data, calculate the required return on asset A having a beta of 0.80 and asset B
                    having a beta of 1.30.
                 d. Draw in the betas and required returns from c for assets A and B on the axes in a. Label the risk
                    premium associated with each of these assets, and discuss them.
                                                    Problem 7 – 26, page 345

                                                               Security Market Line

                                       14                                                  K                    S
           Market Risk
           Required Rate               10
           of Return %




                                            0      0.2      0.4       0.6       0.8            1     1.2        1.4
   c.      kj        RF + [bj
                                                                                      Nondiversifiable Risk (Beta)    Risk
   x(km- RF)]                                                                                                         premium

           Asset A
           kj    =     .09 + [0.80 x (.13 -.09)]
           kj    =     .122

           Asset B
           kj    =     .09 + [1.30 x (.13 -.09)]
           kj    =     .142

   d.      Asset A has a smaller required return than Asset B because it is less risky, based on the beta of 0.80 for Asset A versus
           1.30 for Asset B. The market risk premium for Asset A is 3.2% (12.2% - 9%), which is lower than Asset B's (14.2% -
           9% = 5.2%).

   Business 2039 Winter 2004 – FINAL EXAMINATION                                                                        Page 2
(4)        3.   Taylor Systems has just issued preferred shares. The shares have a 12 percent annual dividend and a $100 stated
                value and were sold at $97.50 per share. In addition, floatation costs of $2.50 per share must be paid.
                        a. Calculate the cost of the preferred shares.
                        b. If the firm sells the preferred stock with a 10 percent annual dividend and nets $90 after floatation
                           costs, what is its cost?
                                                          Problem 9 – 6, page 445
                         kp = Dp  Np

                a. kp          = $12.00        $95.00       =        12.63%

                b. kp          = $10.00        $90.00       =        11.11%

(4)        4.   How does asymmetric information affect the firm’s capital structure decisions? Explain how and why investors
                may view the firm’s financing as signals.
                                                       RQ 10 - 1, page 488

                Asymmetric information results when a firm's managers have more information about operations and future prospects
                than do investors. This additional information will generally cause financial managers to raise funds using a pecking
                order (a hierarchy of financing beginning with retained earnings, followed by debt, and finally, equity) rather than
                maintaining a target capital structure. This might appear to be inconsistent with wealth maximization, but asymmetric
                information allows management to make capital structure decisions which do, in fact, lead to wealth maximization.

                Because of management's access to asymmetric information, the firm's financing decisions can give signals to
                investors reflecting management's view of the stock value. The use of debt sends a positive signal that management
                believes its stock is undervalued. Conversely, issuing new stock may be interpreted as a negative signal that
                management believes the stock is overvalued. This leads to a decline in share price, making new equity financing very

(4)        5.   Wood Shoes, at the quarterly dividend meeting, declared a cash dividend of $1.10 per share for holders of record
                on Monday, July 10. The firm has 300,000 shares of common stock outstanding and has set a payment date of
                July 31. Prior to the dividend declaration, the firm’s key accounts were as follows:
                                 Cash             $500,000                 Dividends Payable            $0
                                                                           Retained earnings     2,500,000
                        a. Show the entries after the meeting adjourned.
                        b. When is the ex dividend date? What is meant by the term “ex dividend”?
                        c. After the July 31 payment date, what values would the key accounts have?
                        d. What effect, if any, will the dividend have on the firm’s total assets?
                        e. Ignoring general market fluctuations, what effect, if any, will the dividend have on the firm’s stock
                            price on the ex dividend date?

                                                         Problem 11 – 1, page 535

      a.                                                       Debit                      Credit
                Retained earnings (Dr.)                      $330,000
                Dividends payable (Cr.)                                                 $330,000

      b.        Ex dividend date is Thursday, July 6. Ex dividend is the period beginning 2 business days prior to the date
                of record during which a stock is sold without the right to receive the current dividend.

      c.        Cash        $170,000                         Dividends payable        $            0

      Business 2039 Winter 2004 – FINAL EXAMINATION                                                                        Page 3
                                                         Retained earnings       $2,170,000

      d.        The dividend payment will result in a decrease in total assets equal to the amount of the payment.

      e.        Notwithstanding general market fluctuations, the stock price would be expected to drop by the amount of
                the declared dividend on the ex dividend date.

(8)        6.   The following financial data on the Bond Recording Company are available:
                              Earnings available for common shareholders                      $800,000
                              Number of common shares outstanding                              400,000
                              Earnings per share ($800,000 ÷ 400,000)                                $2
                              Market price per share                                                $20
                              Price/earnings (P/E) ratio ($40 ÷ $2)                                  10
                The firm is currently contemplating using $400,000 of its earnings to pay cash dividends of $1 per share or
                repurchasing shares at the investment price.
                        a. Approximately how many common shares can the firm repurchase at the $21 per share price using
                            the funds that would have gone to pay the cash dividend?
                        b. Calculate EPS after the repurchase. Explain your calculations.
                        c. If the stock still sells at 10 times earnings, how much will the market price be after the repurchase?
                        d. Compare and contrast the pre- and post- repurchase earnings per share.
                        e. Compare and contrast the shareholders’ position under the dividend and repurchase alternatives.
                            What are the tax implications under each alternative?

                                                       Problem 11 – 16, page 541

      a.        Shares to be repurchased:        $400,000  $21          =    19,047 shares

      b.        EPS:                             $800,000  380,953      =    $2.10 per share

      c.        Market price:                    $2.10 x 10              =    $21.00 per share

      d.        The stock repurchase results in an increase in earnings per share from $2.00 to $2.10.

      e.        The pre-repurchase market price is different from the post-repurchase market price by the amount of the
                cash dividend paid. The post-repurchase price is higher because there are fewer shares outstanding.

                Shareholders, who participate in the stock repurchase plan, would be taxed on the capital gains of the
                proceeds over the price they paid for the shares. Shareholders who receive cash dividends are taxed by the
                dividend tax rate. Whether capital gains or dividend tax rate is preferable depends on the individual
                shareholder’s taxation circumstances.

      Business 2039 Winter 2004 – FINAL EXAMINATION                                                               Page 4
(6)        7.   American Products is concerned about managing cash efficiently. On average, inventories have an age of 90
                days, and accounts receivable are collected in 60 days. Accounts payable are paid approximately 30 days after
                they arise. The firm’s operating-cycle investments are $30 million per year.

                        a.   Calculate the firm’s operating cycle.
                        b.   Calculate the firm’s cash conversion cycle.
                        c.   Calculate the amount of resources needed to support the firm’s cash conversion cycle.
                        d.   Discuss how management might be able to reduce the cash conversion cycle.

                                                        Problem 14 -1, page 697

      a.        Operating cycle               =   Average age of inventories
                OC                                  + Average collection period
                                              =   90 days + 60 days
                                              =   150 days

      b.        Cash Conversion Cycle         =   Operating cycle - Average payment period
                CCC                           =   150 days - 30 days
                                              =   120 days

      c.        Resources needed              =   (total annual outlays  365 days) x CCC
                                              =   [$30,000,000  365] x 120
                                              =   $9,863,014

      d.        Shortening either the average age of inventory or the average collection period, lengthening the average
                payment period, or a combination of these can reduce the cash conversion cycle.

(5)        8.   What is float and what are its three components? Why might the concept of managing float soon be obsolete?
                        Float are funds that have been sent by the payer but are not yet usable funds to the payee.

                        The three components are
                                1. Mail float is the time delay between when payment is placed in the mail and when it is
                                2. Processing float is the time between receipt of the payment and its deposit into the firm’s
                                    account, and
                                3. Clearing float is the time between deposit of the payment and when spendable funds become
                                    available to the firm. This component of float is attributable to the time required for a
                                    cheque to clear the banking system.

                             Electronic funds transfer payment systems now represent the bulk of payments (debit cards and
                             credit cards) this means use of cheques has been to decline…and eventually, as volumes decline,
                             eventually it may become an outmoded means of effecting payment.

      Business 2039 Winter 2004 – FINAL EXAMINATION                                                              Page 5
(4)     9.    Why is the correlation between asset returns important? How does diversification allow risky assets to be
              combined so that the risk of the portfolio is less than the risk of the individual assets in it?
                                                           [Review Question 7-9]

              The correlation between asset returns is important when evaluating the effect of a new asset on the portfolio's overall
              risk. Returns on different assets moving in the same direction are positively correlated, while those moving in
              opposite directions are negatively correlated. Assets with high positive correlation increase the variability of portfolio
              returns; assets with high negative correlation reduce the variability of portfolio returns. When negatively correlated
              assets are brought together through diversification, the variability of the expected return from the resulting
              combination can be less than the variability or risk of the individual assets. When one asset has high returns, the
              other's returns are low and vice versa. Therefore, the result of diversification is to reduce risk by providing a pattern
              of stable returns.

              Diversification of risk in the asset selection process allows the investor to reduce overall risk by combining negatively
              correlated assets so that the risk of the portfolio is less than the risk of the individual assets in it. Even if assets are not
              negatively correlated, the lower the positive correlation between them, the lower the resulting risk.

(24)    10.   You are planning to establish a manufacturing company to produce micro chips that are used in micro wave
              ovens. It will take an initial investment of $2,000,000 in equipment and leasehold improvements to establish the
              business and this will require you to invest your total life savings. The business will be financed entirely
              through owners equity because you feel that the terms and conditions lenders will impose will restrict the growth
              potential of the business in the long run.

              You have done considerable research into the business and have determined that it will cost you $1.12 in direct
              materials and direct labour to produce each chip. You have estimated other costs as follows:

                                           Monthly lease costs for the firm                                        $3,450
                                           Annual Salaries and Administrative expenses                           $167,500
                                           Annual depreciation expenses on equipment                             $255,000
                                           Selling, advertising and promotion expenses annually                  $145,700

              Calculate the annual and monthly break even point for this business in both numbers of units produced and sold,
              as well as in sales dollars assuming that the selling price per micro chip is $7.44.

              When doing market research for your business you determined that the global market for microwave ovens is
              14,500,000 units annually. Given the strong competition in the microchip market you estimate there is a 25%
              probability that you can capture 0.5% of the market; a 50% probability that you can capture 1% of the market
              and a 25% probability that you can capture a 1.5% market share in your first year of operation. Your business
              will face a corporate tax rate of 20%.

              a.   Calculate the annual and monthly break even point in units and in sales dollars.
              b.   What is the probability that your business will not breakeven? Probability that you will breakeven? Draw a
                   correctly labeled diagram of the breakeven chart showing the relationships between costs, volume and
              c.   What is your projected Gross Margin, EBIT and Net Income at the expected level of sales? What is the
                   firm’s DOL and DFL at this same level of projected sales?
              d.   If the yield on 91-day Treasury bills is currently 2%, the market premium for risk is 7.16% and the beta
                   coefficient for this firm is 1.5, what is your required return on this business? What is your expected ROE?
                   What is the projected EVA (economic value added)? Would you recommend proceeding with this business
                   opportunity? Explain.

       Business 2039 Winter 2004 – FINAL EXAMINATION                                                                              Page 6
        $                                                     Total
     Costs,                                                   Revenue
                     Break even
      and            TR=TC
    Profits                                                 Total Costs


                                                         Fixed Costs

                                                96,456   Volume of Production
                                                         and Sales (in
                                                         numbers of units)

Business 2039 Winter 2004 – FINAL EXAMINATION                           Page 7
              Fixed Costs:
                          Annual lease                                $41,400
                          Salaries and Admin                          167,500
                          Selling and Admin                           145,700
                          Depreciation                                255,000
                          TOTAL FIXED COSTS                           609,600

              Selling Price per unit                                    $7.44
              Variable Cost per unit                                     1.12
              Unit Contribution margin                                   6.32
              Annual Break even point in units                          96456 ##
              Annual Break even point in sales dollars            $717,630.38

              Monthly Break even point in units                         8,038
              Monthly Break even point in sales dollars            $59,802.53

              Total Market Size                                      14500000

              Projected Sales =                                       1078800
              Projected Cost of Goods Sold =                           162400
              Projected Gross Margin =                                 916400
              Projected EBIT at expected volume of sales =            306,800
              Projected net income at expected sales volume =         245,440
              Projected ROE =                                          12.27%
              Required return on the firm =                            12.74%
              EVA =                                                    -0.47%
              DOL=                                                        2.99
              DFL =                                                       1.00

                                                                  Weighted                     Weighted
                                                                  Possible                    and Squared
               Probability    Possible Sales Volume (units)       Volume         Deviations Deviations
                     0.25                  72,500                     18,125         -72,500 1314062500
                       0.5                145,000                     72,500                0           0
                     0.25                 217,500                     54,375           72500 1314062500
                             Expected Sales Volume in units =        145,000    Variance =     2628125000
                                                                        Standard Deviation = 51265.24164

                             Z value =                            -0.94692431
                             Area between point of interest and mean = 32.64%
                             Probability of breaking even =            82.64%
                             Probability of not breaking even =        17.36%

      There is a strong possibility that our sales volume will exceed the breakeven point. However, our best estimate
                  is that there will be a negative EVA (our expected return is less than the required return) so we DO
                  NOT expect to be compensated sufficiently for the risk associated with this business. Therefore, we
                  should not proceed with the business.

Business 2039 Winter 2004 – FINAL EXAMINATION                                                         Page 8
(12) 11.   Grainger Corp., a supplier of fitness equipment, is trying to decide which proposed projects in its investment
           opportunities schedule (IOS) it should undertake. The firm’s cost of capital schedule and investment
           opportunities schedule are presented as follows:

                                                     Cost of capital schedule
                        Range of new financing            Source      Weight After-tax cost
                        1 - $600,000                 Debt              0.50           6.30%
                                                     Preferred equity  0.10          12.50%
                                                     Common equity     0.40          15.30%

                        $600,000 - $1,000,000        Debt                  0.50               6.30%
                                                     Preferred equity      0.10              12.50%
                                                     Common equity         0.40              16.40%

                        $1,000,000 and above         Debt                  0.50               7.80%
                                                     Preferred equity      0.10              12.50%
                                                     Common equity         0.40              16.40%

                                   Investment opportunities schedule
                   Investment opportunity Internal rate of return                             Cost

                   Project H                              14.50%                                $200,000
                   Project G                              13.00%                                 700,000
                   Project K                              12.80%                                 500,000
                   Project M                              11.40%                                 600,000

                   a. Complete the cost of capital schedule by calculating the WACC and MCC for the various ranges of
                      new financing.
                   b. Identify those projects that you recommend Grainger Corp. undertake in the next year.
                   c. Illustrate your recommendations by drawing a graph of Grainger’s costs and opportunities.
                   d. Explain why certain projects are recommended and other(s) are not.

                                                Problem 9 – 20, page 451

   a.      WACC: 0 to $600,000                    = (.5)(6.3%) + (.1)(12.5%) + (.4)(15.3%)
                                                  = 3.15% + 1.25% + 6.12%
                                                  = 10.52%

           WACC: $600,001 - $1,000,000            = (.5)(6.3%) + (.1)(12.5%) + (.4)(16.4%)
                                                  = 3.15% + 1.25% + 6.56%
                                                  = 10.96%

           WACC: $1,000,001 and above             = (.5)(7.8%) + (.1)(12.5%) + (.4)(16.4%)
                                                  = 3.9% + 1.25% + 6.56%
                                                  = 11.71%

   Business 2039 Winter 2004 – FINAL EXAMINATION                                                             Page 9
      See part c for the MCC schedule.

b.    All four projects are recommended for acceptance since the IRR is greater than the MCC across the full
      range of investment opportunities.

c.                                                             IOS and MCC
              Weighted                   H

            Cost of Capital/
              Return (%)
                                13                                          K

                                12                                                                      MCC
                                                                                     A                        IOS

                                     0       200   400   600   800   1000   1200   1400   1600   1800    2000

                                                    Total New Financing/Investment ($000)

d.    In this problem, projects H, G, and K would be accepted since the IRR for these projects exceeds the
      MCC. The remaining project, M, would be rejected because the MCC is greater than the IRR.

Business 2039 Winter 2004 – FINAL EXAMINATION                                                                       Page 10
(6)    12.   You are considering the purchase of a stock that is currently trading for $51.25 on the Toronto Stock Exchange.
             As part of your analysis you are going to estimate the intrinsic value of the stock. If the stock is undervalued
             you will purchase it.

             The firm that you are interested in paid a dividend last year of $2.14 per share. Based on your analysis,
             investor's require a return on this type of stock of 9.5%. You believe that dividends will grow at a rate of 30%
             for the coming year, 20% in the second year, and then grow at a constant rate of 3% for the foreseeable future
             after that.

             What is your estimate of the stock's intrinsic value?
             Is the stock under valued, over valued or fairly valued?
             Do you recommend purchase of the stock based on your analysis?

               Discount rate =                    0.095
                 Time      Dividend/PV     PV Factor Present Value
                        1         $2.78      0.9132          $2.54
                        2         $3.34      0.8340          $2.78
                        2        $52.90      0.8340         $44.12
                                      Instrinsic Value=     $49.44

                Based on our analysis the instrinsic value of the stock is $49.44
                Since Intrinsic Value < Market Value, the stock appears to be over priced.
                Based on this analysis, this is a stock that should NOT be purchased. We would expect the market to become
                efficient to this information and the market value should fall to equal the intrinsic value in a short period of
                time. Any investor purchasing the stock now should expect to face a capital loss in the near future.

                                NOTE: Answer one only of the following to earn bonus points.

For Class WA
(3) 13. What is the CSC? Why might you consider completing this now?

For Class WB
(3) 13. What is the common name for monotropa uniflora? What is it and why is it important?

        / 92          TOTAL

      Business 2039 Winter 2004 – FINAL EXAMINATION                                                            Page 11