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Fall 04 Exam File

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					QUIZ 1; BA340; 10:00;                  Fall 2004                  Write your Name and SS# on the BACK of the page
Optional: Select a 4-digit identification code (to post scores in public folder):________________________
On quantitative problems show all work... Credit is given for the method, not the answer.
1. (5 points) Briefly explain the connection between the following two concepts:
     i. The goal of corporate financial management should be to "maximize shareholder wealth".
     ii. Equity is both the residual claim and the claim with control over the operation of the corporation.

         Answer: Because equity is the residual claim, operating the corporation in a manner consistent with equity's
         interests is necessarily also consistent with other claimants' interests. If everyone else must be paid first, the
         equity claim is maximized only when other claims have been satisfied.

2. Use the following balance sheets and income statement for the Stellar Corp. to answer the next 2 questions:
                                            Balance Sheets                                           2002 Income Stmt.
Assets              12/31/01 12-31-02          Liab & SH Equity          12-31-01 12-31-02                sales    1215
cash                     200         225       accruals                         65         70            -costs    -850
A/R                       85          90       A/P                            270         290            -depr.     -70
inventory                450         425       long-term debt                 600         650            EBIT       295
  gross FA         1750        1950            Equity                                                 -interest     -85
 -accum. depr.       800        870              paid-in capital              500         500             EBT       210
net FA                   950        1080         retained earnings            250         310              -tax     -60
   total assets         1685        1820           total claims              1685        1820                NI     150

     2a. (4 points) How much did Stellar pay in dividends during 2002?

          Answer:
          You need to use the "statement of RE" relation to solve this problem:
          REend = REstart + NI - DIV
          310 = 250 + 150 - DIV
          DIV = 90

     2b. (4 points) Find the "operating cash flow" for 2002 and (4 points) carefully explain what this number means.
         Answer: OCF = EBIT – tax + Depreciation = 295 – 60 + 70 = 305

         Operating Cash Flow is the cash flow generated by the firm from producing and selling goods and services. It
         does not include interest expense because interest is a financing expense. Depreciation is added back because
         depreciation is a non-cash expense.

3. The Auk Corp purchased an asset on 12-31-03 for $50,000. The asset is being depreciated straight-line over 4 years.
       3a. (4 points) Create a depreciation schedule that shows the depreciation and book value of the asset for each of
       the 4 years.
               Answer:
                                      time % depreciation        $ depreciation       book value
                                          0                                             $50,000
                                          1             25%            $12,500          $37,500
                                          2             25%            $12,500          $25,000
                                          3             25%            $12,500          $12,500
                                          4             25%            $12,500                 0

       3b. (4 points) If the Auklet Corp sells the asset on 12-31-05 for $32,000, find the net, after-tax, cash effect (cash
       flow) from the sale. The tax rate is 30%.
              Answer:
              accounting profit = selling price - book value = MV - BV =32,000 - 25,000 = 7,000
              tax = (accounting profit) (tax rate) = 7,000 (.3) = 2100
              net cash effect = cash received from the sale - tax = 32,000 – 2,100 = $29,900
QUIZ 1; BA340; 12:00;                 Fall 2004                   Write your Name and SS# on the BACK of the page
Optional: Select a 4-digit identification code (to post scores in public folder):________________________
On quantitative problems show all work... Credit is given for the method, not the answer.
1. (5 points) Briefly distinguish between “financial intermediaries” and “financial markets”. Provide an example of a
financial intermediary and an example of a financial market.

         Answer: In financial markets, investors (the suppliers of funds) purchase securities (claims) that have been
         issued by the “users of funds”. An example of a financial market is the New York Stock Exchange, where
         investors trade equity securities that have been issued by large corporations.
         In financial intermediaries, investors (the suppliers of funds) purchase the securities (claims) of the financial
         intermediary, not the securities of the ultimate user of the funds. The financial intermediary then channels the
         funds to the ultimate users of funds. An example of a financial intermediary is a commercial bank.

      2. Use the following balance sheets and income statement to answer the next 3 questions:
                                             Balance Sheets                                              2002 Income Stmt.
Assets                12/31/01 12-31-02          Liab & SH Equity       12-31-01 12-31-02                     sales    1215
cash                       200        225        accruals                      65          70                -costs    -850
A/R                         85         90        A/P                          270         290                -depr.     -70
inventory                  450        425        long-term debt               600         650                EBIT       295
  gross FA           1750       1950             Equity                                                   -interest     -85
 -accum. depr.         800        870              paid-in capital            500         500                 EBT       210
net FA                     950       1080          retained earnings          250         310                  -tax     -60
   total assets           1685       1820           total claims             1685        1820                    NI     150

      2a. (4 points) How much did Stellar pay in dividends during 2002?

          Answer:
          You need to use the "statement of RE" relation to solve this problem:
          REend = REstart + NI - DIV
          310 = 250 + 150 - DIV
          DIV = 90

     2b. (8 points) Find the “free cash flow” for 2002 and (4 points) carefully explain what this number means.

          Answer: FCF = OCF – NFAI – NCAI
               OCF = EBIT – tax + depreciation = 295 – 60 + 70 = 305
               NFAI = gross FAend – gross FAstart = 1950 – 1750 = 200
               NCAI = nWCend = nWCstart (ignoring “notes payable)
                       = (CA – CL)end - (CA – CL)start
                       = {(225 + 90 + 425) - (70 + 290)} – {(200 + 85 + 450) - (65 + 270)} = -20
               FCF = 305 – 200 – (-20) = 125

          Free cash flow measures the amount of cash flow available to the firm’s investors (the suppliers of financing).
          Free cash flow represents the cash remaining after the firm has met all other obligations, and after the firm has
          made all investments in assets. If positive, the firm has generated cash that is available to the firm’s suppliers
          of financing.

3. (4 points) Which of the following correctly describes the equity claim (as opposed to debt claims):
(circle the letter corresponding to the correct answer.)

       a. Equity is the residual claim; has unlimited life; pays cash flows of “dividends”; dividends are “after-tax”
       b. Equity is the residual claim; has unlimited life; pays cash flows of “interest”; interest is “after-tax”
       c. Equity is a priority claim; has a fixed maturity; pays cash flows of “dividends”; dividends are “after-tax”
       d. Equity is a priority claim; has a fixed maturity; pays cash flows of “interest”; interest is “after-tax”

              Correct answer: a
QUIZ 2; BA340; 10:00; Fall 2004                          Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. (21 points) It is currently 12-31-04, and the Scaup Corp. has the following balance sheet:
12-31-2004 Balance Sheet
Assets          12-31-04 12-31-05                  Claims           12-31-04 12-31-05
cash                   200         260             A/P                  1,700      2,210
A/R                  2,150       3,750             Notes payable        1,500      1,500
Inv.                 2,250       3,000             L.T. debt            1,000      2,240
net FA               1,050       1,140             equity: (PIC)          550        550
                                                   equity: (RE)           900      1,650
total assets         5,650       8,150             total claims         5,650      8,150

Create a pro forma 12-31-2005 balance sheet for the Scaup Corp. based on the above balance sheet and the following
information (round to the closest $1):
 Scaup is planning to expand its product line in 2005. The expansion is expected to have the following effects:
      total sales (all on credit) are expected to increase by 30% during 2005, to $15,000.
      the "inventory turnover ratio" will be 3.0.
      the average collection period will increase to 90 days.
 The Scaup Corp. is planning a $280 investment in fixed assets on 1-1-05. These assets will be depreciated straight-
     line to zero over 4 years.
 The depreciation on existing assets will be $120 in 2005.
 Scaup expects Notes payable (seasonal working capital bank loan) will remain at $1,500.
 Any additional external financing needed will come from long-term debt.
 Scaup does not plan to issue any new equity during 2005.
 Scaup plans to pay out $150 as dividends.
 Scaup has a "net profit margin" of 6%, and a gross profit margin of 40%.

       Answer:
       cash: Since no better information, use % of sales method: cash = (200)(1.30) = 260
       A/R: ACP = A/R/(sales/360) = 90; A/R = 3,750
       Inv.: inventory turnover = 3.0 = CGS/Inv = 9000/Inv; Inv = 3000
         CGS is found from the gross profit margin:
         gross profit margin = .40 = (sales - CGS)/sales = (15,000-CGS)/15,000; CGS = 9,000
       nFAend = nFAstart + purchases - depreciation
         = 1,050 + 280 - (280/4 + 120) = 1140
       Total Assets = cash + A/R + Inv + nFA = 8,150
       Total Claims = Total Assets = 8,150
       A/P: Since no better information, use % of sales method: A/P = (1700)(1.30) = 2210
       Note payable: constant at 1,500
       Equity PIC: since no new issues of equity, stays constant at 1,650.
       Equity RE: REend = REstart + NI - DIV = 900 + (.06)(15,000) - 150 = 1,650
       L.T. Debt: The plug: LTDebt = 8,150 - 1,650 - 550 - 1,500 - 2,210 = 2,240




2. (4 points) Briefly explain why the "inventory turnover" ratio for a company with highly seasonal sales may be
misleading. How could you change the calculation of "inventory turnover" to minimize this problem?

        Answer:
        For a company with highly seasonal sales, the ending balance sheet "inventory" account may be much larger or
        smaller that the average or typical inventory during the year. The "inventory turnover" ratio will therefore be
        much smaller or larger than is actually the case. To minimize this problem, the "inventory turnover" ratio can
        be calculated using "average" inventory during the year where the average is calculated using, for example,
        monthly or quarterly ending inventories.
QUIZ 2; BA340; 12:00; Fall 2004                          Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. (21 points) It is currently 12-31-04, and the Scaup Corp. has the following balance sheet:
12-31-2004 Balance Sheet
Assets          12-31-04 12-31-05                  Claims           12-31-04 12-31-05
cash                   200         260             A/P                  1,700      2,210
A/R                  2,150       3,750             Notes payable        1,500      1,500
Inv.                 2,250       3,000             L.T. debt            1,000      2,240
net FA               1,050       1,140             equity: (PIC)          550        550
                                                   equity: (RE)           900      1,650
total assets         5,650       8,150             total claims         5,650      8,150

Create a pro forma 12-31-2005 balance sheet for the Scaup Corp. based on the above balance sheet and the following
information (round to the closest $1):
 Scaup is planning to expand its product line in 2005. The expansion is expected to have the following effects:
      total sales (all on credit) are expected to increase by 30% during 2005, to $15,000.
      the "inventory turnover ratio" will be 3.0.
      the average collection period will increase to 90 days.
 The Scaup Corp. is planning a $280 investment in fixed assets on 1-1-05. These assets will be depreciated straight-
     line to zero over 4 years.
 The depreciation on existing assets will be $120 in 2005.
 Scaup expects Notes payable (seasonal working capital bank loan) will remain at $1,500.
 Any additional external financing needed will come from long-term debt.
 Scaup does not plan to issue any new equity during 2005.
 Scaup plans to pay out $150 as dividends.
 Scaup has a "net profit margin" of 6%, and a gross profit margin of 40%.

      Answer:
      cash: Since no better information, use % of sales method: cash = (200)(1.30) = 260
      A/R: ACP = A/R/(sales/360) = 90; A/R = 3,750
      Inv.: inventory turnover = 3.0 = CGS/Inv = 9000/Inv; Inv = 3000
        CGS is found from the gross profit margin:
        gross profit margin = .40 = (sales - CGS)/sales = (15,000-CGS)/15,000; CGS = 9,000
      nFAend = nFAstart + purchases - depreciation
        = 1,050 + 280 - (280/4 + 120) = 1140
      Total Assets = cash + A/R + Inv + nFA = 8,150
      Total Claims = Total Assets = 8,150
      A/P: Since no better information, use % of sales method: A/P = (1700)(1.30) = 2210
      Note payable: constant at 1,500
      Equity PIC: since no new issues of equity, stays constant at 1,650.
      Equity RE: REend = REstart + NI - DIV = 900 + (.06)(15,000) - 150 = 1,650
L.T. Debt: The plug: LTDebt = 8,150 - 1,650 - 550 - 1,500 - 2,210 = 2,240




2. (4 points) In the context of analyzing a firm's performance using financial ratios, briefly explain what is meant by the
terms "time-series" analysis and "cross-sectional" analysis.

       Answer: A "time-series" analysis compares ratios of the same company over a series of time periods.
       A "cross-sectional" analysis, compares the ratios of different companies in the same industry.
QUIZ 3; BA340; 10:00; Fall 2004                        Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. An investment has a current price of $1,200. The investment is expected to provide a single (risky) cash flow of
$1,400 in one year. The required rate of return on the investment is 12%.
       1a. (4 points) Find the value (today) of the investment and use the value to explain whether or not this is a good
       investment.

              Answer: Value = PV (future cash flows) = $1400 / (1.12) = $$1,250
              Because value > current price, this is a good investment.

       1b. (4 points) Find the expected rate of return on the investment and use the expected rate of return to explain
       whether or not this is a good investment.

              Answer:
              Expected rate of return: $1200 = $1400 / (1+k) 1,        k = 16.67%
              Because expected rate of return > required rate of return, this is a good investment

2. (4 points) You buy an asset for $850, and sell it 3 months later for $865. Find the EAR (effective annual rate) on
your investment.

       Answer:
       3 month rate: 850 = 865/(1+k)1;    k = .0176471 = 1.76471%
       EAR = {1+.0176471)}12/3 - 1 = .0724788 = 7.24788%

3. (4 points) You take out a $22,000 car loan that is to be paid back in 60 equal monthly payments at an APR of 8%.
What is your monthly payment?

              Answer: $22,000 = (monthly payment) (PVIFA.08/12, 60) = (monthly payment) (49.318433)
                 monthly payment = $446.08

4. (4 points) An asset is expected to provide the following cash flows:
Years 1 through 28: $50 each year.
Year 29: $1050
If the required rate of return is 6.0%, find the value of the asset.

       Answer:
       Value = PV(expected future CF)
       = $50(PVIFA6%, 28) + $1000(PVIF6%, 28)
       = $50(13.406164) + $1000(.195630) = $670.31+ $195.63 = $865.94

5. (5 points) Your financial planner offers you a retirement annuity that has a cost today of $50,000. The retirement
annuity will pay you 30, equal, annual, annuity payments, each of which is $36,000. The first of these annuity payments
will occur 20 years from today and the last will occur 49 years from today.
Find the expected return (%) on this investment. You do not need to get a numerical answer, just set up the equation that
solves for the expected return.

         Answer: $50,000 = $36,000(PVIFAk%, 30) (1/(1+k)19)
QUIZ 3; BA340; 12:00; Fall 2004                        Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. (4 points.) The required rate of return is 9%. Find the value of an asset that provides the following cash flows:
                    year 1          year 2        year 3         year 4
                     $100            $300          $500         $1,200

       Answer: Value = PV (future cash flows) = 100/(1.09) + 300/(1.09)2 + 500/(1.09)3 + 1,200/(1.09)4

2. You deposit $600 today in a bank account paying a stated interest rate of 5.5% APR, compounded monthly.
        2a. (4 points) What will be your bank account balance at the end of 5 years?

                  Answer: FV = 600 (1 + (.055/12))(5)(12) = (600)(1.3157038) = $789.42


         2b. (4 points) What is the EAR (effective annual return) on this bank account?

                  Answer: (1+EAR) = (1 + (.055/12))(12) ; EAR = .0564079 = 5.64079%

         2c. (4 points) Briefly explain why the EAR is higher than the APR.

                  Answer: The EAR recognizes the fact that when compounding more frequently than annually, you are
                  earning more interest on interest. For example, in the second month, you are earning interest not only
                  on the $600 that you have deposited, but also on the interest that you earned during the first month. In
                  contrast, with annual compounding, you earn no interest on interest until the second year.


3. (4 points) The required rate of return is 6.0%. Find the value of an asset that provides the following estimated cash
flows: (Use the annuity formula in finding your answer.)
Years          Expected future cash flows
1-17           $60
18             $1060

       Answer: Value = PV (future cash flows) = 70 (PVIFA6%,18) + 1000(PVIF6%,18)
       = 60 (10.827603) + 1000 (.3503438) = 1000.00

4. (5 points) 2 years ago today, you purchased a bond for $925.00. Each year (1 year ago and today), you received
interest payments of $60.00. If you sell the bond today for $1,050.00, what was your realized, annual rate of return (%)
over the two year period? You do not need to get a numerical answer, just set up the equation that solves for the rate of
return.

       Answer: 925.00 = 60.00/(1+k) + 60.00/(1+k) 2 + 1050/(1+k)2
QUIZ 4; BA340; 10:00;                 Fall 2004                   Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. A portfolio contains 2 assets: $100 invested in asset A, and $500 invested in asset B
Asset A: expected return (kA) = 8.0%;           standard deviation (σA) = 12%;      beta (βA) = 0.50
Asset B: expected return (kB) = 14.0%;          standard deviation (σB) = 15%       beta (βB) = 1.25
(Choose the one, best answer for the following multiple choice questions.)
       1a. (4 points) the expected return (kP) of the portfolio is:
               a. kP < 12.5%                    Answer:
               b. 12.5% ≤ kP < 13.5%            kP = 1/6(8.0%) + 5/6(14.0%) = 13.0%
               c. 13.5% ≤ kP < 14.5%
               d. 14.5% ≤ kP
               e. not enough information
       1b. (4 points) the standard deviation (σP) of the portfolio is:
               a. σP < 11%                      Answer: portfolio standard deviation is not a
               b. 11% ≤ σP < 13%                weighted average, so we do not have enough
               c. 13% ≤ σP < 15%                information .
               d. 15% ≤ σP
               e. not enough information
       1c. (4 points) the beta (βP) of the portfolio is:
               a. βP < .70                      Answer:
               b. .70 ≤ βP < .90                βP = 1/6(0.50) + 5/6(1.25) = 1.125
               c. .90 ≤ βP < 1.10
               d. 1.10 ≤ βP
               e. not enough information
       1d. (4 points) If the expected return on the market portfolio (k M) is 12%, find the risk-free rate of interest (RF).

               Answer: Use the CAPM:
               ki = RF + βi(kM - RF)
               13% = RF + 1.125(12.0% - RF) = RF = 4.0%

2. (4 points) A large, well-diversified portfolio has the following possible outcomes for the coming year:
          State of the Economy        Probability        Return
                    Good                  .30              25%
                    Normal                .40              10%
                    Bad                   .30              -10%
        Find the expected return of this portfolio.

               Answer: kportfolio = .30(25%) + .40(10%) + .30(-10 %) = 8.5%

3. (5 points) Carefully explain the process used to estimate beta. Include a graph with your answer...label the axes.

       Answer: The beta for a stock can be estimated from a graph of the stock's historical returns (y-axis) versus stock
       market historical returns (x-axis). Beta is the slope of the "best-line" (a least-squares, linear regression line)
       drawn through these points.
QUIZ 4; BA340; 12:00;                Fall 2004                   Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. The Redtail Corp. is currently evaluating a potential investment in fixed assets. The investment has a beta of 1.15.
The (expected) market return (kM) is 10.0%, and the risk free rate (RF) is 2.5%. The investment has an initial cost of
$800, and is expected to provide the following cash flows:
        Year 1 Year 2
        $325       $550
       1a. (3 points) Find the required rate of return on the investment.

              Answer:
              Required rates of return can be found using the CAPM:
              ki = RF + βi(kM - RF) = 2.5% + 1.15(10.0% - 2.5%) = 11.125%


       1b. (3 points) Find the value of the investment, and
       (2 points) use the value to decide whether or not this is a good investment.

              Answer:
              Value = PV(expected future cash flows), evaluated at the required rate of return:
              Value = $325/(1+.11125)1 + $550/(1+.11125)2 = 292.46 + 445.39 = $737.85
              Since the value of the investment ($737.85) is less than the cost of the investment ($800), this is not a
              good investment.

       1c. (3 points) Write the equation that would solve to give the expected rate of return on the investment.
       (You do not need to get a numerical answer, just set-up the equation.), and
       (3 points) carefully explain whether the expected rate of return is greater than, equal to, or less than the required
       rate of return.

              Answer:
              Price = PV(CF), using the expected rate of return;
              $800 = $325/(1+k)1 + $550/(1+k)2 3
              Because this is not a good investment, the expected rate of return must be less than the required rate of
              return. Alternatively, if the investment could be purchased at its value of $732.56, you would be
              expecting to earn exactly your required rate of return of 11.625%. Since the price is higher than the
              current price, your expected rate of return must be lower than 11.625%.

2. (5 points) Carefully explain why the CAPM is generally not a useful approach to estimate the required rate of return
to use in evaluating an investment in fixed assets by a corporation.

       Answer: To use the CAPM, you need an estimate for beta. To estimate a beta, you need a time-series of historical
       returns with which to run a least squares regression. While a return history is readily available for publicly traded
       securities (such as common stock) it generally NOT available for real assets, such as the investment in fixed
       assets by corporations.

3. The return (%) of Goldeneye Goldfields Inc.’s common stock is uncorrelated to the stock market as a whole (the
market portfolio). What (if anything) do you know about the following: (Briefly explain your answers.)
      3a. (2 points) the beta of Goldeneye’s common stock?

              Answer: Since the asset’s returns are uncorrelated to the market portfolio, its beta must be 0.

       3b. (2 points) the standard deviation of goldeneye’s common stock

              Answer: The standard deviation could be anything. There is not enough information in the problem to say
              anything about the stock’s standard deviation.

       3c. (2 points) the required return of Goldeneye’s common stock?
               Answer: Since the beta is 0, the required return must be the risk-free rate.
QUIZ 5; BA340; 10:00;               Fall 2004                   Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. The Widgeon Corp.’s bonds have the following characteristics:
Coupon: 13.0%, paid annually
Maturity: 24 years
Par value: $1000.00
Current price: $931.65
       1a. (3 points) Draw a time line showing the payments promised by the bonds.


       1b. (5 points) Show that the YTM (yield to maturity, kd) of the bonds is 14.0%.

              Answer:
              B0 = C(PVIFAkd, n)
              931.65 = $130(PVIFA13%,24) + $1000(PVIF13%,24)

       1c. (2 points) Widgeon has another outstanding bond issue that has the same YTM as the above bonds (14%) If
       these other bonds have a par value of $1000 and a current market value of $1,000, what coupon do they have?

              Answer: Bonds sell at par value when the coupon rate equals the interest rate. So the coupon rate must
              also be 14% ($140)

2. (5 points) Identify and explain the conditions under which a corporation is most likely to "call" its outstanding bonds.

       Answer: A corporation is most likely to call its outstanding bonds when the market interest rate is less than the
       coupon rate on the existing, outstanding bonds. The corporation can then reissue the bonds at a lower coupon
       rate.

3. (4 points) Briefly describe the term "indenture".

       Answer: A debenture is a bond that does not have specific real assets backing the promised payments.

4. (6 points) Draw an example of an “upward sloping” yield curve. Label the axis(s).
Identify and briefly explain two factors that affect the shape of the yield curve.

       Answer:
       X Axis: time to maturity
       Y Axis: interest rate
       Factors
       1. Expectations for future interest rates: If the investors expect interest rates to increase, then the yield curve will
       be steeper.
       2. Maturity premium: Because long-term debt securities have more interest rate risk, investors demand higher
       interest rates for longer term securities.
       3. Supply and Demand: Changes in the supply and demand for loanable funds at different maturities will cause
       changes in market interest rates at different maturities.
QUIZ 5; BA340; 12:00;               Fall 2004                   Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. The Widgeon Corp.’s bonds have the following characteristics:
Coupon: 13.0%, paid annually
Maturity: 24 years
Par value: $1000.00
Current price: $931.65
       1a. (3 points) Draw a time line showing the payments promised by the bonds.


       1b. (5 points) Show that the YTM (yield to maturity, kd) of the bonds is 14.0%.

              Answer:
              B0 = C(PVIFAkd, n)
              931.65 = $130(PVIFA13%,24) + $1000(PVIF13%,24)

       1c. (2 points) Widgeon has another outstanding bond issue that has the same YTM as the above bonds (14%) If
       these other bonds have a par value of $1000 and a current market value of $1,000, what coupon do they have?

              Answer: Bonds sell at par value when the coupon rate equals the interest rate. So the coupon rate must
              also be 14% ($140)

2. (5 points) Briefly explain what is meant by a "convertible" bond.

    Answer: Some bonds give the bondholder the right to convert the bond to common stock. These bonds usually
    stipulate specific time periods, and conversion rates at which bonds may be converted.

3. (4 points) Briefly distinguish between "senior" and "subordinated" bonds.

       Answer:
       Senior bonds have higher priority, while subordinate bonds have lower priority.

4. (6 points) Draw an example of an “upward sloping” yield curve. Label the axis(s).
Identify and briefly explain two factors that affect the shape of the yield curve.

       Answer:
       X Axis: time to maturity
       Y Axis: interest rate
       Factors
       1. Expectations for future interest rates: If the investors expect interest rates to increase, then the yield curve will
       be steeper.
       2. Maturity premium: Because long-term debt securities have more interest rate risk, investors demand higher
       interest rates for longer term securities.
       3. Supply and Demand: Changes in the supply and demand for loanable funds at different maturities will cause
       changes in market interest rates at different maturities.
QUIZ 6; BA340; 10:00 and 12:00;               Fall 2004         Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. The common stock of the Bunting Corporation has a current market price of $28.50 per share. The common stock
currently pays a yearly dividend of $3.50 per share, and this dividend is expected to stay constant in the future.
       1a. (4 points) Find Bunting's "cost of common stock" (ks ; "investors’ required rate of return").
           Answer:
           P0 = PV(expected future dividends) = DIV/ ks
           $28.50 = $3.50 / ks ;    ks = 12.28%

        1b. (5 points) In 1a, you found an expected rate of return: the discount rate that makes the present value of the
        future cash flows equal to the current price. Carefully explain why we usually assume that this discount rate is
        also investors' required rate of return.

               Answer:
               We rely on the "efficient market hypothesis"; in financial markets, price quickly converges to fundamental
               value. When price = value, expected returns must be equal to required returns:
               Value = CF(1)/(1+k) + CF(2)/(1+k)2 + CF(3)/(1+k)3 + …….            where k = required rate of return
               Price = CF(1)/(1+k) + CF(2)/(1+k)2 + CF(3)/(1+k)3 + …….            where k = expected rate of return

        1c. (4 points) What other method could be used to estimate Bunting's “cost of common stock” (ks). Why does
        this other method often provide a better estimate of ks?

               Answer: the CAPM could also be used to estimate ks. Unlike preferred stock and bonds (for which the
               promised cash flows are known with certainty), the cash flows (dividends) from common stock are
               extremely difficult to estimate; common stock dividends are entirely at the discretion of management, and
               often vary with company performance. Remember, common stock is the residual claim.

2. (6 points) The common stock of the Krug Corp. does not currently pay dividends. It is expected that: 1) an initial
dividend of $2.00 will be paid in two years; 2) the annual dividend will then grow at a rate of 25% for the next two years
(years three, and four); and 3) after the fourth year, the annual dividend will grow at a constant rate of 3% per year,
forever. If the current price of Krug common stock is $15.00, find "investors’ required rate of return", ks). (You do not
need to get a numerical answer...just set-up the equation that would solve for ks.)

         Answer:
year:              1           2                      3                      4                      5             6
DIV:               0       $2.00         $2.00 (1.25) =         $2.50 (1.25) =        $3.125 (1.03) =       g = 3%
                                                  $2.50                $3.125              $3.21875       (forever)

         15.00 = 2.00 / (1+ks)2 + 2.50 / (1+ks)3 + 3.125 / (1+ks)4 +[ (3.21875) / (ks - .03) ] [1 / (1+ks)4 ]

3. (6 points) A mutual fund manager finds that when a company reports earnings that are better than expected, the
company's common stock tends to outperform the overall stock market over the next 90 days. Carefully explain whether
or not this is a violation of the "efficient markets hypothesis".

        Answer: This is a direct violation of the efficient markets hypothesis. If this were true, then it is possible to
        identify and profit from incorrectly prices securities. The mutual fund manager could consistently beat the
        market simply by buying the stock of companies that report better than expected earnings.
QUIZ 7; BA340; 10:00;                  Fall 2004        Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. (20 points.) The Myna Corp is analyzing the possible purchase of a $1,200,000 computer-based inventory and order
management system. The system will be depreciated straight-line to zero over three years. The system has an expected
life of five years, after which the system will be worthless. In each of the 5 years, the investment would save the
company $500,000 in order processing costs. As a result of the investment, inventory would decline by $180,000,
accounts receivable (A/R) would increase by $40,000, and accounts payable (A/P) would increase by $60,000. The
changes in inventory, accounts receivable, and accounts payable would occur immediately The tax rate is 30% and the
cost of capital is 12%. Find the net present value (NPV), the internal rate of return (IRR), and the profitability index (PI)
of the investment. (You do not need to get numerical answers...just set-up the equations.)

Answer: (all in (000)
        time                          0             1              2              3              4              5
        OCF                                       470            470            470            350            350
        chg. in nWC               +200                                                                       -200
        net CI                   -1,200
        total incr CF            -1,000           470            470            470            350            150

       Depr.(1-3) = 1,200/3 = 400
       Depr.(4-5) = 0
       Sales (1-5) = 0
       Costs(1-5) = -500
       OCF(1-3) = (S-C)(1-T) + DT = (0 - (-500))(.7) + 400(.3) = 470
       OCF(4-5) = (S-C)(1-T) + DT = (0 - (-500))(.7) + 0(.3) = 350
       nWC(0) = +180 - 40 + 60 = +200
       nWC(5): reverse: -200
       nCI(0) = -1,200

NPV = value - cost = 470/(1.12)1 + 470/(1.12)2 +470/(1.12)3 +350/(1.12)4 +150/(1.12)5 - 1,000
IRR: k that makes NPV = 0: 470/(1+IRR)1 + 470/(1+IRR)2 +470/(1+IRR)3 +350/(1+IRR)4 +150/(1+IRR)5 - 1,000 = 0
PI: value / cost: PI = [470/(1.12)1 + 470/(1.12)2 +470/(1.12)3 +350/(1.12)4 +150/(1.12)5]/ 1,000



2. (5 points) Carefully what is meant by the term "incidental effects" (or "side-effects") in a capital budgeting analysis.

       Answer: Incidental effects are effects on the firm's CF resulting from changes in the firm's existing operations.
       For example, if an investment project affects the sales of existing products, then these effects are incremental and
       should be included in the capital budgeting analysis. Incidental effects are often very important in strategic
       decisions, and are often difficult to estimate accurately.
QUIZ 7; BA340; 12:00;                  Fall 2004        Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. (20 points.) The Myna Corp is analyzing the possible purchase of a $1,200,000 computer-based inventory and order
management system. The system will be depreciated straight-line to zero over three years. The system has an expected
life of five years, after which the system will be worthless. In each of the 5 years, the investment would save the
company $500,000 in order processing costs. As a result of the investment, inventory would decline by $180,000,
accounts receivable (A/R) would increase by $40,000, and accounts payable (A/P) would increase by $60,000. The
changes in inventory, accounts receivable, and accounts payable would occur immediately The tax rate is 30% and the
cost of capital is 12%. Find the net present value (NPV), the internal rate of return (IRR), and the profitability index (PI)
of the investment. (You do not need to get numerical answers...just set-up the equations.)

Answer: (all in (000)
        time                          0             1              2              3              4              5
        OCF                                       470            470            470            350            350
        chg. in nWC               +200                                                                       -200
        net CI                   -1,200
        total incr CF            -1,000           470            470            470            350            150

       Depr.(1-3) = 1,200/3 = 400
       Depr.(4-5) = 0
       Sales (1-5) = 0
       Costs(1-5) = -500
       OCF(1-3) = (S-C)(1-T) + DT = (0 - (-500))(.7) + 400(.3) = 470
       OCF(4-5) = (S-C)(1-T) + DT = (0 - (-500))(.7) + 0(.3) = 350
       nWC(0) = +180 - 40 + 60 = +200
       nWC(5): reverse: -200
       nCI(0) = -1,200

NPV = value - cost = 470/(1.12)1 + 470/(1.12)2 +470/(1.12)3 +350/(1.12)4 +150/(1.12)5 - 1,000
IRR: k that makes NPV = 0: 470/(1+IRR)1 + 470/(1+IRR)2 +470/(1+IRR)3 +350/(1+IRR)4 +150/(1+IRR)5 - 1,000 = 0
PI: value / cost: PI = [470/(1.12)1 + 470/(1.12)2 +470/(1.12)3 +350/(1.12)4 +150/(1.12)5]/ 1,000



2. (5 points) Carefully explain the economic significance of "net present value" (NPV).

       Answer: Net present value measures the value created by the investment. A positive NPV means that we have
       identified an investment that provides the suppliers of capital with more than their required rate of return. The
       NPV measures the value created by this additional rate of return. Because equity is the residual claim, this
       created value accrues to equity; consistent with the goal of financial management to maximize shareholder
       wealth.
QUIZ 8; BA340; 10:00; Fall 2004                        Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. (5 points) The Van Horne Construction Company is evaluating the possibility of purchasing a new D9 tractor for
$125,000. It would replace a D8 tractor which would be sold for $12,000. The D8 has a book value of $8,000 and is
being depreciated straight-line to zero at $2,000 per year. The D9 would be depreciated straight-line to zero over 5 years.
The D9 would support increased billings of $25,000 per year since it could complete larger jobs more quickly than the
smaller D8. Operating costs would be higher with the D9. Fuel and maintenance costs with the D8 are estimated to be
$13,000 per year. Fuel and maintenance costs with the D9 would be about $18,000. Labor and other costs run about
$18,000 per year with either tractor. Van Horne's tax rate is 30%. Find the "net capital investment" at time 0: (netCI(0);
the net cash effect from buying and selling fixed assets at time 0).

              Answer: This will have three parts: the cost of the D9, the selling price (MV) of the D8, and the tax effect
              from selling the D8 at a value other than its book value:
              1. Buy D9: -$125,000
              2. Sell D8: +$12,000
              3. Tax on sale of D8: accounting profit = MV - BV = $12,000 - $8,000 = $4,000
                           tax (to pay) = $4,000 (.30) = $1,200
              net cash effect = -$125,000 + $12,000 - $1,200 = -$114,200

2. (20 points) The Sleet Corp. is evaluating the possibility of adding a new product to its existing product line. This
expansion project would require an initial investment of $870, and would result in estimated future incremental cash
flows of $100 per year, forever (a perpetuity). Sleet's tax rate is 30%.
The risk of the expansion project is considered comparable to that of Snow's existing operations.
Sleet's current (target) capital structure is summarized below:
          Equity: Common stock: 1,000,000 shares outstanding, Current market price: $4.00 per share;
                                       Annual dividends: expected dividend for next year: $0.50 per share;
                                       Dividends are expected to grow at 3% per year, forever.
          Debt: Bonds:                 6,000 bonds outstanding; Par Value: $1,000; Annual coupon: 6%;
                                       Current market price: $908.92 per bond; Maturity: 15 years.
            2a. (4 points) Draw a time line showing the cash flows expected from one of Sleet's bonds. Use those cash
            flows to show that Sleet's cost of debt (kd) is 7.0%.
                    Answer: 908.92 = 60(PVIFA7.0%,15) + 1000(PVIF7.0%,15)

          2b. (4 points) Draw a time line showing the cash flows expected from a share of Sleet's common equity. Use
          those cash flows to estimate Snow's cost of common equity (ks).
                 Answer: P0 = (DIV(1))/( ks - g); $4.00 = $0.50/( ks - .03); ks = 15.5%

          2c. (6 points) Find Sleet's WACC (weighted average cost of capital).
                  Answer:
                  Total MV common equity = 1,000,000($4) = $4,000,000
                  Total MV bonds = 6,000($908.82) = $5,452,920
                  Total capital = $4,000,000 + 5,452,920 = $9,452,920
                  wd = $5,452,920 / $9,452,920 = .58
                  ws = $4,000,000 / $9,452,920 = .42
                  WACC = wd kd(1-T) + wsks
                  = (.58)(7.00%)(1-.30) + (.42)(15.5%) = 9.352%%

          2d. (4 points) Find the IRR for the expansion project. Use the IRR to explain whether or not this is a good
          investment
                 Answer:
                 IRR: 870 = 100/IRR
                 IRR = 11.49%
                 Since the IRR > cost of capital of 9.352%, this is a good investment; NPV > 0
                 The investment creates value.

          2e. (2 points) Briefly explain why the information, “The risk of the expansion project is considered
          comparable to that of Snow's existing operations” is necessary to do this problem.
                  Answer: The WACC is the required rate of return on the firm’s existing assets. If the risk of the
                  investment is different from the risk of existing assets, then it would be the wrong cost of capital for
                  this analysis.
QUIZ 8; BA340; 12:00; Fall 2004                        Write your Name and SS# on the BACK of the page
On quantitative problems show all work... Credit is given for the method, not the answer.
1. (5 points) The Van Horne Construction Company is evaluating the possibility of purchasing a new D9 tractor for
$125,000. It would replace a D8 tractor which would be sold for $12,000. The D8 has a book value of $8,000 and is
being depreciated straight-line to zero at $2,000 per year. The D9 would be depreciated straight-line to zero over 5 years.
The D9 would support increased billings of $25,000 per year since it could complete larger jobs more quickly than the
smaller D8. Operating costs would be higher with the D9. Fuel and maintenance costs with the D8 are estimated to be
$13,000 per year. Fuel and maintenance costs with the D9 would be about $18,000. Labor and other costs run about
$18,000 per year with either tractor. Van Horne's tax rate is 30%.
Find the incremental operating cash flow during year two (OCF(2) ).

              Answer:
                           Sell D8 and Buy D9          Keep D8                     Incremental
Depreciation (2)           D9; Depr(2) = $25,000       D8; Depr(2) = $2,000        Depr(2) = $23,000
Sales (2)                                                                          Sales(2) = $25,000
Costs (2)                  Costs(2) = $18,000          Costs(2) = $13,000          Costs(2) = $5,000

              OCF = (S-C) (1-T) + DT =(25,000 - 5,000) (1-.3) + 23,000 (.30) = $20,900

2. (20 points) The Sleet Corp. is evaluating the possibility of adding a new product to its existing product line. This
expansion project would require an initial investment of $870, and would result in estimated future incremental cash
flows of $100 per year, forever (a perpetuity). Sleet's tax rate is 30%.
The risk of the expansion project is considered comparable to that of Snow's existing operations.
Sleet's current (target) capital structure is summarized below:
          Equity: Common stock: 1,000,000 shares outstanding, Current market price: $4.00 per share;
                                       Annual dividends: expected dividend for next year: $0.50 per share;
                                       Dividends are expected to grow at 3% per year, forever.
          Debt: Bonds:                 6,000 bonds outstanding; Par Value: $1,000; Annual coupon: 6%;
                                       Current market price: $908.92 per bond; Maturity: 15 years.
            2a. (4 points) Draw a time line showing the cash flows expected from one of Sleet's bonds. Use those cash
            flows to show that Sleet's cost of debt (kd) is 7.0%.
                    Answer: 908.92 = 60(PVIFA7.0%,15) + 1000(PVIF7.0%,15)

          2b. (4 points) Draw a time line showing the cash flows expected from a share of Sleet's common equity. Use
          those cash flows to estimate Snow's cost of common equity (ks).
                 Answer: P0 = (DIV(1))/( ks - g); $4.00 = $0.50/( ks - .03); ks = 15.5%

          2c. (6 points) Find Sleet's WACC (weighted average cost of capital).
                  Answer: Total MV common equity = 1,000,000($4) = $4,000,000
                  Total MV bonds = 6,000($908.82) = $5,452,920
                  Total capital = $4,000,000 + 5,452,920 = $9,452,920
                  wd = $5,452,920 / $9,452,920 = .58
                  ws = $4,000,000 / $9,452,920 = .42
                  WACC = wd kd(1-T) + wsks
                  = (.58)(7.00%)(1-.30) + (.42)(15.5%) = 9.352%%

          2d. (4 points) Find the IRR for the investment. Use the IRR to explain whether or not this is a good
          investment.
                 Answer:
                 IRR: 870 = 100/IRR
                 IRR = 11.49%
                 Since the IRR > cost of capital of 9.352%, this is a good investment; NPV > 0
                 The investment creates value.

          2e. (2 points) Briefly explain why the information, “The risk of the expansion project is considered
          comparable to that of Snow's existing operations” is necessary to do this problem.
                  Answer: The WACC is the required rate of return on the firm’s existing assets. If the risk of the
                  investment is different from the risk of existing assets, then it would be the wrong cost of capital for
                  this analysis.

				
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