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Sample Answers to Corporate Finance Law document sample
DEPARTMENT OF FINANCE, INSURANCE & LAW COLLEGE OF BUSINESS ILLINOIS STATE UNIVERSITY FIL 440 - Ahlgrim Midterm 100 points NAME _______________________________________ NOTE: For all bond questions, always assume semiannual coupons unless stated otherwise in the question. MULTIPLE CHOICE – Circle the BEST response for each of the following questions. 4 points each 1. What is the decision that determines which assets a company should purchase? a. Capital structure b. Corporate form c. Asset substitution d. Capital budgeting e. Risk/return tradeoff 2. You are given the following cash flows. What is the present value (t = 0) if the discount rate is 8 percent, rounded to a whole dollar? a. $2,500 b. $4,804 c. $5,302 d. $7,963 e. $10,000 3. What is the standard deviation of the following investment? Scenario Probability Return Boom 0.10 18% Normal 0.50 12% Recession 0.40 -6% a. 12% b. 90% c. 9% d. 24% e. 2.9% 4. You deposit $10,000 in a bank each year for 10 years. If you earn 6% on your deposits, what is the future value of your deposits? a. 131,808 (if you assume end of year PMT) b. 73,601 c. 43,553 d. 77,156 e. 139,716 (if you assume beginning of year PMT) 5. When compared to sole proprietorships, which of the following is NOT an advantage of the corporate form of ownership? a. Limited liability of owners b. Ease of raising large amounts of capital c. Ease of transfer of ownership d. Reduced taxation e. All of the above 6. Suppose you buy a $40,000 car with no money down. You finance the car over 5 years at a fixed interest rate of 9%. What is the amount of principal repayment that is contained in the first monthly payment? a. 300 b. 486 c. 786 d. 750 e. 524 (this is the closest answer) 7. Garfield Industries is expanding its operations. Garfield anticipates that the expansion will increase sales by $1,000,000 and the costs of goods sold by $700,000. Depreciation expenses will rise by $50,000 and interest expense will increase by $150,000. The company's tax rate is 40%. How much will net income increase or decrease, as a result of the expansion? a. No change. b. $40,000 increase. c. $60,000 increase. d. $100,000 increase. e. $180,000 increase. 8. Coolidge Cola is forecasting the following income statement: Sales $30,000,000 Operating costs excluding 20,000,000 depreciation Depreciation 5,000,000 Operating income (EBIT) $ 5,000,000 Interest expense 2,000,000 Taxable income (EBT) $ 3,000,000 Taxes (40%) 1,200,000 Net income $ 1,800,000 With the exception of depreciation, all other non-cash revenues and expenses sum to zero. Congress is considering a proposal which will allow companies to depreciate their equipment at a faster rate. If this provision were put in place, Coolidge's depreciation expense would be $8,000,000 (instead of $5,000,000). If this proposal were to be implemented, what would be the company's net cash flow? a. $2,000,000 b. $4,000,000 c. $6,800,000 d. $8,000,000 e. $9,800,000 9. A share of common stock has just paid a dividend of $3.00. If the expected long-run growth rate for this stock is 5 percent, and if investors require an 11 percent rate of return, what is the price of the stock? a. $50.00 b. $50.50 c. $52.50 d. $53.00 e. $63.00 10. On January 1, you charge $1,000 on your credit card which has an APR of 19.9%, compounded daily. Suppose your credit card company allows you the opportunity to defer any payments until December 31. What is the balance on your account on December 31? a. 1,098 b. 1,199 c. 1,216 d. 1,220 e. 1,289 11. Harmeling Enterprises had a decline in net operating profit after taxes (NOPAT). Which of the following definitely cannot help explain this decline? a. Sales revenues decreased. b. Costs of goods sold increased. c. Depreciation increased. d. Interest expense increased. e. Taxes increased. 12. Assume that you wish to purchase a bond with 30 years to maturity, a coupon of 10%, and a face value of $1,000. If you require a 9 percent yield to maturity on this investment, what is the price of the bond? a. $905.35 b. $1,102.74 c. $1,103.19 d. $1,106.76 e. $1,149.63 WRITTEN ANSWER – Answer the following questions on separate paper (put your name on each sheet of paper and number the questions). SHOW ALL WORK AND WRITE LEGIBLY NUMERICAL QUESTIONS. Choose any FOUR of questions 13-17. 7 Points Each 13. You are given that the beta of a stock is 0.6, the risk free rate is 7%, and the market risk premium is 5%. Draw the security market line for this situation. A stock analyst estimates that, based on the future prospects of the company, the stock is expected to earn 9%. Evaluate the attractiveness of this stock. Required return = 7+0.6*5=10%. Since the stock is expected to earn less than it should based on its amount of risk, it is unattractive. The stock lies below the security market line. 14. The last dividend paid by Jay Bee Company was $1.00. The company's growth rate is expected to be 25% next year, 15% in the 2nd year, and then dividends are expected to grow at a rate of 8% forever. Jay Bee's required rate of return on equity (rs) is 11 percent. What is the current price of Jay Bee's common stock? D1=1.25, D2=1.25*1.15=1.44, D3=1.55 P2=1.55/(.11-.08)=51.75 P0=1.25/1.11+(1.44+51.75)/1.11^2=44.30 15. Suppose a 2-year bond has a coupon of 10% and a face value of $1,000. The bond sells for $932.26. a. Write out the equation that can be solved to determine the yield-to- maturity of this bond. b. Is the yield-to-maturity equal to 14%? Why or why not? c. If the bond is callable at $1,120 in one year, without performing any calculations, which is larger, the YTC or the YTM? Why? 50 50 50 1050 a. 932 .26 = 1 + 2 + 3 + 4 ytm ytm ytm ytm 1 + 1 + 1 + 1 + 2 2 2 2 b.Plug into equation: 50 50 50 1050 1 + 2 + 3 + 4 = 932 .26 0.14 0.14 0.14 0.14 1 + 1 + 1 + 1 + 2 2 2 2 Since the equation equates to the current price, yes YTM=14% c. compare the CFs if the bond: (1) is called or (2) is not called (1) you get $120 premium at time 1 (2) you get only $100 worth of coupons, later than time 1 Since you get more money faster if the bond is called, the YTC must be higher. 16. Calculate free cash flow for 2005 based on the following data. Income Statement 2005 Revenue 400 Interest expense 25 COGS 150 SG&A 75 Depreciation 50 Dividends 50 Tax rate 30% Balance Sheet 2005 2004 Cash 25 5 Other Current Assets 125 95 Net fixed Assets 200 100 Total assets 350 200 Current liabilities 75 50 Long-term debt 75 0 Shareholder equity 200 150 Total Liab & Equity 350 200 FCF=NOPAT-∆OC NOPAT=(400-150-75-50)*(1-0.30)=87.50 ∆OC=(350-75)-(200-50)=125 FCF=-37.50 17. Compare the following two companies’ financial statements and use DuPont Analysis to determine why one company’s ROE is higher than the other’s. Income Statement Blackjack Co. Poker Inc. Revenue 75,000 50,000 Operating Costs 65,000 40,000 EBIT 10,000 10,000 Interest 3,000 3,000 EBT 7,000 7,000 Taxes (40%) 2,800 2,800 Net Income 4,200 4,200 Balance Sheet Blackjack Co. Poker Inc. Current Assets 10,000 5,000 Net Fixed Assets 90,000 75,000 Total Assets 100,000 80,000 Current Liab 20,000 10,000 Long-term debt 40,000 40,000 Total Liab 60,000 50,000 Common Stock 15,000 10,000 Retained Earnings 25,000 20,000 Total Liab and Equity 100,000 80,000 4200 75000 100000 ROE ( BJ ) = × × = 10.5% 75000 100000 40000 4200 50000 80000 ROE ( P) = × × = 14.0% 50000 80000 30000 Poker has higher ROE because they have lower expenses (PM is higher) and are more levered (asset multiplier is higher). However, they are not as efficient (TATO is less). CONCEPTUAL QUESTIONS. Choose any THREE of questions 18-21. 8 Points Each 18. What is the market-to-book ratio of a company? What does it indicate? Explain why the market-to-book ratio of Pfizer would likely be significantly higher than a generic drug manufacturer’s. Captures intangibles like brand name. Pfizer likely has more intangibles, including research knowledge and technology. 19. Explain why the interest rate on 5-year bonds issued by Microsoft would be much lower than the interest rate on 20-year bonds issued by General Motors. What are the risks of these two bonds? I=r*+IP+DRP+LRP+MP GM is less creditworthy (higher DRP), the bonds are longer term (higher MP), and perhaps they are callable. 20. What is the goal of corporations? Does this goal benefit society or does it lead to problems? Explain your response. Maximize stock price. To increase stock price, companies produce more desirable products at lower prices and are more efficient. To achieve this they hire the best employees, increase pay and offer other benefits (e.g., State Farm Park). As the company grows, they hire even more people increasing employment. In general, this is all good for society. 21. Suppose you are a loan officer for a bank. Explain how you would use a company’s financial statements to evaluate a company’s request for a loan. Looking only at the financial statements, what information would be most useful to you? I’d be interested in how much debt the company has (debt ratio), its ability to cover it’s current debt (TIE ratio) and its ability to survive in the short term (liquidity)