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UNIVERSITY OF MANITOBA

Faculty of Management
Department of Accounting and Finance

9.220 Corporation Finance Professors: A.Dua, J.Falk, A.Paseka, and R. Scott
Mid-term Examination VERSION A March 2, 2007; 9:30 a.m. - 11:30 a.m.

I. Multiple Choice Section:


1 mark each

1. Which of the following statements is most correct?
a) A hostile takeover is the main method of transferring ownership interest in a
corporation.
b) The corporation is a legal entity created by the state and is a direct extension of the
legal status of its owners and managers. That is, the owners and managers are the
corporation.
c) Unlimited liability and limited life are two key advantages of the corporate form over
other forms of business organization.
d) In part due to limited liability and ease of ownership transfer, corporations
have less trouble raising money in financial markets than other organizational
forms.
e) Although stockholders of the corporation are insulated by limited legal liability, the
legal status of the corporation does not protect the firms managers in the same way.

2. Which of the following are likely to reduce agency conflicts between stockholders and
managers?
a) Paying managers a large fixed salary.
b) An increase in the threat of a corporate takeover.
c) Placing restrictive covenants in debt agreements.
d) All of the statements above are correct.
e) Statements b and c are correct.
THIS QUESTION DELETED FROM EXAM SCORE CALCULATIONS

3. Last year Aldrin Co. had a negative net Cash Flow of the Firm, yet its cash on the balance
sheet increased. Which of the following might explain these events?
a) Aldrin issued long-term debt.
b) Aldrin repurchased some of its common stock.
c) Aldrin sold some of its assets.
d) Statements a and b are correct.
e) Statements a and c are correct.

4. Given 12% per year, compounded quarterly, what is the equivalent rate per year
compounded semi annually?
a) 6%
b) 6.09%
c) 11 %
d) 12%
e) 12.18%

5. An investment should be made in period 0 if
a) desired consumption in period 0 is less than income.
b) desired consumption in period 1 is greater than income.
c) return on the investment is greater than the relevant interest rate.
d) return on the investment is less than the relevant interest rate.
e) both a & b.
f) none of the above.

6. Which of the following would present an arbitrage situation to an investor?
a) A bank sets its rate on risk-free borrowing above its rate on lending.
b) A bank sets its rate on risk-free borrowing below its rate on lending.
c) A bank sets its rate on risk-free borrowing equal to its rate on lending.
d) Any time the risk-free borrowing rate is not equal to the lending rate.
e) Any of the above is true.
f) None of the above is true.

7. An individual has income of $20,000 in period 0 and $42,000 in period 1. A real
investment opportunity that costs $15,000 in period 0 is worth $18,000 in period 1. The
market interest rate is 6%. What is the maximum possible consumption in period 1 if the
individual consumes $16,000 in period 0 and follows the NPV rule?
a) $ 25,000
b) $ 30,750
c) $ 35,604
d) $ 46,240
e) $ 48,340
f) None of the above is correct.

Answer: c
Individual must borrow $11,000 from period 1 income which comes at a cost of
$11,000 (1.06) = $11,660. Therefore, max period 1 dollars is: $42,000 - $11,660 +
$18,000 = $48,340

8. The present value of an individuals life-time income is $50,000. The individual consumes
$20,000 in period 0 and $44,000 in period 1. Equilibrium interest rate is 10% per period.
What is the NPV of an investment opportunity that makes this consumption pattern
possible?
a) $ 10,000
b) $ 20,000
c) $ 25,340
d) $ 30,000
e) More information is needed to answer the question with certainty.
f) None of the above is correct.

9. Which of the following bank accounts has the highest effective annual return?
a) An account that pays 10 percent interest per year with monthly compounding.
b) An account that pays 10 percent interest per year with daily compounding.
c) An account that pays 10 percent interest per year with annual compounding.
d) An account that pays 9.85 percent interest per year with daily compounding.
e) All of the investments above have the same effective annual return.

Answer: b
The bank account which pays the highest nominal rate with the most frequent rate
of compounding will have the highest EAR. Consequently, statement b is the correct
choice.

10. Which of the following investments will have the highest future value at the end of 5
years? Assume that the effective annual rate for all investments is the same.
a) A pays $50 at the end of every 6-months for the next 5 years (a total of 10
payments).
b) B pays $50 at the beginning of every 6-months for the next 5 years (a total of 10
payments).
c) C pays $500 in 5 years.
d) D pays $100 at the end of every year for the next 5 years (a total of 5 payments).
e) E pays $100 at the beginning of every year for the next 5 years (a total of 5
payments).

Answer: e
As the effective rate is the same, the correct answer must be the one that has the
largest amount of money compounding for the longest time. This would be
statement e.

11. A growing annuity will provide you with 6 annual payments with the first payment of
$8,000 occurring 4 years from now. The equilibrium market rate of interest is 10%/year
compounded annually and the growth rate of payments is 10%/year. The present value
today (rounded to cents) of this annuity is
a) $48,000.
Page 2 of 13
b) $43,636.36.
c) $39,669.42.
d) $36,063.11.
e) $32,784.65.
f) none of the above.

12. Which of the following statements is most correct?
a) The NPV method assumes that cash flows will be reinvested at the cost of
capital while the IRR method assumes reinvestment at the IRR.
b) The NPV method assumes that cash flows will be reinvested at the risk free rate
while the IRR method assumes reinvestment at the IRR.
c) The NPV method assumes that cash flows will be reinvested at the cost of capital
while the IRR method assumes reinvestment at the risk-free rate.
d) The NPV method does not consider the inflation premium.
e) The NPV method does not make any assumptions in regards to the reinvestment rate
of cash flows.
f) The IRR method does not consider all relevant cash flows, and particularly cash
flows beyond the payback period.

13. Projects L and S each have an initial cost of $10,000, followed by a series of positive cash
inflows. Project L has total, undiscounted cash inflows of $16,000, while S has total
undiscounted inflows of $15,000. Further, at a discount rate of 10 percent, the two projects
have identical NPVs. Which projects NPV will be more sensitive to changes in the
discount rate?
a) Project S.
b) Project L.
c) Both projects are equally sensitive to changes in the discount rate since their NPVs
are equal at all costs of capital.
d) Neither project is sensitive to changes in the discount rate, since both have NPV
profiles which are horizontal.
e) The solution cannot be determined unless more information is known.

14. Two mutually exclusive projects each have a cost of $10,000. The total, undiscounted cash
flows from Project L are $15,000, while the undiscounted cash flows from Project S total
$13,000. Their NPV profiles cross at a discount rate of 10 percent. Which of the following
statements best describes this situation?
a) The NPV and IRR methods will select the same project if the cost of capital is
greater than 10 percent; for example, 18 percent.
b) The NPV and IRR methods will select the same project if the cost of capital is less
than 10 percent; for example, 8 percent.
c) To determine if a ranking conflict will occur between the two projects the cost of
capital is needed as well as an additional piece of information.
d) Project L should be selected at any cost of capital, because it has a higher IRR.
e) Project S should be selected at any cost of capital, because it has a higher IRR.

15. Green Grocers is deciding among two mutually exclusive projects. The two projects have
the following cash flows:

Project A Project B
Year Cash Flow Cash Flow
0 -$50,000 -$30,000
1 10,000 6,000
2 15,000 12,000
3 40,000 18,000
4 20,000 12,000

The companys cost of capital is 10 percent. What is the net present value (NPV) of the
project with the higher internal rate of return (IRR)?
a) $ 7,090
b) $ 8,360
c) $11,450
d) $12,510
Page 3 of 13
e) $15,200

Answer: e
Enter the cash flows for each project into the cash flow register on the calculator and
get the NPV and IRR.
NPVA = $15,200; IRRA = 21.3811%.
NPVB = $7,092; IRRB = 19.2783%.
Project A has the highest IRR, so the answer is $15,200.

16. Two projects being considered are mutually exclusive and have the following projected
cash flows:
Project A Project B
Year Cash Flow Cash Flow
0 -$50,000 -$50,000
1 15,990 0
2 15,990 0
3 15,990 0
4 15,990 0
5 15,990 $100,560

At what rate (approximately) do the NPV profiles of Projects A and B cross?
a) 6.5%
b) 11.5%
c) 16.5%
d) 20.0%
e) The NPV profiles of these two projects do not cross.
f) More information is needed to answer this question with certainty.

Answer: b
Solve for crossover rate using the differential project CFs, CFA-B
Inputs: CF0 = 0; CF1 = 15,990; Nj = 4; CF2 = -84,570.
Output: IRR = 11.49%. The crossover rate is 11.49%.

17. The pure expectations hypothesis states that the forward rate over second period is:
a) equal to the spot rate expected to prevail over the second period.
b) equal to the first period spot rate.
c) always greater than the spot rate in period one.
d) always greater than the period 3 forward rate.
e) none of the above.

18. Assume that the pure expectations theory holds. Which of the following statements about
Treasury bill rates is most correct?
a) If 2-year rates exceed 1-year rates, then the market expects interest rates to rise.
b) If 2-year rates are 7 percent, and 3-year rates are 7 percent, then 5-year rates must
also be 7 percent.
c) If 1-year rates are 6 percent and 2-year rates are 7 percent, then the market expects 1-
year rates to be 6.5 percent in one year.
d) Statements a and c are correct.
e) Statements b and c are correct.
f) None of the above is correct.

Answer: a
Statement a is correct; the other statements are false.
Knowing 2-year rates and 3-year rates permits no inference regarding 5-year rates.
However, knowing 2-year rates and 3-year rates beginning in two years would
permit applying the expectations theory to infer 5-year rates. Given the data
concerning 1-year and 2-year rates in statement c, the market expects 1-year rates
in one year to be 8%.

19. A 2-year zero-coupon Treasury bill with a maturity value of $1,000 has a price of
$873.4387. A 1-year zero-coupon Treasury bill with a maturity value of $1,000 has a price
of $938.9671. If the pure expectations theory is correct, for what price should 1-year zero
Page 4 of 13
a) $798.89
b) $824.66
c) $852.28
d) $930.21
e) $989.11
f) None of the above is correct.

20. Pickles Corp. is a company that sells bottled iced tea. The company is thinking about
expanding its operations into the bottled lemonade business. Which of the following cash
flows should the company incorporate into its capital budgeting decision as it decides
whether or not to enter the lemonade business?
a) If the company enters the lemonade business, its iced tea sales are expected to fall
$500,000 per year as some consumers switch from iced tea to lemonade.
b) Two years ago the company spent $3 million to renovate a building for a proposed
project that was never undertaken. If the project is adopted, the plan is to have the
lemonade produced in this building.
c) If the company doesnt produce lemonade, it can lease the building to another
company and receive after-tax cash flows of $500,000 a year.
d) Statements a and c are correct.
e) All of the statements above are correct.

21. The financial section of the Global and Mailer News quotes the 3-year zero-coupon
Treasury bill at 5.4 percent. Also, the current 2-year zero-coupon Treasury bill is 5 percent.
If the real risk-free rate is 3 percent and is expected to remain constant, and the pure
expectations theory is correct, what is the average annual expected inflation for the 1-year
period during Year 1 to 2?
a) 0.4%
b) 2.4%
c) 2.7%
d) 2.8%
e) 3.1%
f) 2.43%
g) 0.50%
h) 5.8%
i) 6.2%
j) More information is needed to answer the question.

2 marks each:

22. Brooks Sisters operating income (EBIT) is $500,000. The companys tax rate is 40
percent, and its operating cash flow is $450,000. The companys interest expense is
$100,000. What is the companys net cash flow?
a) $ 350,000
b) $ 390,000
c) $ 450,000
d) $ 550,000
e) $ 600,000
f) $ 950,000
g) $1,050,000

Answer: a
EBIT $500,000 (Given)
Interest $100,000 (Given)
EBT $400,000
Taxes (40%) $160,000 (Given)
NI $240,000

Operating cash flow = EBIT(1 - T) + DEP
$450,000 = $500,000(0.6) + DEP
$150,000 = DEP.

Page 5 of 13
NCF = $240,000 +$150,000
= $390,000

23. You are a financial analyst and one of your clients has just advised you that they intend to
retire 25 years from today. After a thorough analysis of your clients needs, you determine
that a sum of $1,050,000 will be required to meet her financial needs when she retires.
Your client would like to start making quarterly contributions to a retirement savings plan
(the first contribution will be 3 months from today) and continue those payments until she
retires. If you can invest her contributions at an effective annual rate of return of 8%, how
much will your clients quarterly payment need to be?
a) $14,851.14
b) $3,362.88
c) $3,487.73
d) $38,888.89
e) $14,362.72

24. A stock expects to its next annual dividend in one year in the amount of $2.00 per share.
The dividend is expected to fall by 5 percent each year, forever. The companys required
rate of return is 15 percent. Which of the following statements is most correct?
a) The companys current stock price is $10.
b) The companys current stock price is $20.
c) The companys stock price 6 years from now is expected to be $7.35
d) Only statements a and c are correct.
e) Only statements b and c are correct.
f) All of the statements above are correct.

Answer: e
Statement e is the correct choice; all the statements are correct.
Statement a is correct; P
0
= $2/(0.15 + 0.05) = $10.
Statement b is incorrect;
Statement c is correct; $10(0.95)5 = $7.74.

25. J RJ Corporation recently issued 10-year bonds at a price of $1,000. These bonds pay $60 in
interest every six months. Their price has remained stable since they were issued, that is,
they still sell for $1,000. Due to additional financing needs, the firm wishes to issue new
bonds that would have a maturity of 10 years, a par value of $1,000, and pay $40 in
interest every six months. If both bonds have the same yield, how many new bonds must
J RJ issue to raise $2,000,000 cash?
a) 2,400
b) 2,596
c) 3,000
d) 5,000
e) 4,275

Answer: b

Since the old bond issue sold at its maturity (or par) value, and still sells at par, its
yield (and the yield on the new issue) must be 6 percent semiannually. The new
bonds will be offered at a discount:

Financial calculator solution:

Inputs: N = 20; I = 6; PMT = 40; FV = 1,000.
Output: PV = -$770.60; VB = $770.60.

Number of bonds: $2,000,000/$770.60 = 2,596 bonds.*

*Rounded up to next whole bond.

26. A stock is expected to have a dividend per share of $0.60 at the end of this year. The
dividend is expected to grow at a constant rate of 7 percent per year, and the stock has a
required return of 12 percent per year. What is the expected price of the stock five years
Page 6 of 13
a) $12.02
b) $15.11
c) $15.73
d) $16.83
e) $21.15

Answer: d
Step 1: Using the Gordon constant growth model, calculate todays price:
P
0
= D
1
/(k
s
- g)
= $0.60/(0.12 - 0.07)
= $12.00.

Step 2: Calculate the price of the stock 5 years from today, assuming g = 7% per
year:
= P
0
= (1.07)5
= $12.00 = (1.07)5
= $16.83.

Or, the dividend 6 years from today will be
= .60(1.07)
5

=.84153104

And the price at time 5 will = .84153104 / (.12-.07) = $16.83062077




The Long Answer section continues on the next page

Page 7 of 13
II. Long Answer Section: (35 marks)

Answer each question in the spaces provided. Show all relevant work (i.e., formulas and
substitutions). Do NOT indicate which buttons were pushed on your calculator. Do not
round any intermediate calculations. Final dollar answers should be rounded to two
decimal places. Final interest rate answers should be rounded to 4 decimal places if stated
as a percentage (12.345678%), or 6 decimal places if expressed as a decimal (0.123456787)
unless otherwise specified. Other final answers may be rounded to 6 decimal places, unless
otherwise specified.

QUESTION ONE (12 marks)
IBM stock has an expected return of 16.985856% per year (effective). Dividends are paid
quarterly. The next dividend of $5 is to be paid 2 months from today. Dividends will grow at a
rate of 3% every quarter. Following the dividend paid twenty (20) months from now, dividends
are expected to grow at a rate of 2% every quarter. Following the dividend paid fifty (50)
months from now, their will be two changes: the dividend frequency will change from quarterly
to semi-annually, and the dividends are expected to decrease at a rate of 1% every six (6)
months, forever. What should IBMs stock be selling for today?

Data setup:
Effective quarterly rate r = (1.16985856)
1/4
1 = 4%
C
2
= 5
C
24
= 5(1.03)
6
(1.02) = $6.08966671

C
56
= 5(1.03)
6
(1.02)
10
(1-.01) = $7.204938279

13 . 33 $
) 04 . 1 ( 7 . 32
) 1 ( annuity growing 3% of
7 . 32 $
04 . 1
03 . 1
1
.03 .04
5

1
1
1 annuity growing 3% of PV
3 / 1
1 0
7
1
1 -
=
=
+ =
=
(
(

|
.
|

\
|

=
(
(

|
.
|

\
|
+
+

T
T
r PV PV
r
g
g r
C




37 . 41 $
) 04 . 1 /( 74 . 53
) 1 /( annuity growing 2% of
74 . 53 $
04 . 1
02 . 1
1
.02 .04
6.08966671

1
1
1 annuity growing 2% of PV
3 / 20
20 0
10
24
20
=
=
+ =
=
(
(

|
.
|

\
|

=
(
(

|
.
|

\
|
+
+

=
T
T
r PV PV
r
g
g r
C


Effective semi - annual rate r = (1.16985856)
1/2
1 = 8.16%

Page 8 of 13
$115.41
91 . 40 37 . 41 13 . 33 price Current
91153766 . 40 $
) 0816 . 1 (
66 . 78
) 1 (
perpetuity decreasing final of
65653143 . 78 $
) 01 . 0 ( 0816 . 0
) 01 . 0 1 ( ) 02 . 1 ( ) 03 . 1 ( 5
perpetuity decreasing final of
6 / 50
0
10 6
56
50
=
+ + =
=
=
+
=


=

=
T
r
FV
PV
g r
C
PV

Page 9 of 13

QUESTION TWO (8 marks)
You have just negotiated a 5 year mortgage on $100,000 amortized over 30 years at a rate of 7%.
The mortgage will be renegotiated every 5 years. At the end of the 5th year you renegotiate the
mortgage rate. You agree to continue to pay the same mortgage rate of 7%, but you will begin
paying an additional $100 each month towards the mortgage (that is from month 61 onwards you
make an original monthly scheduled payment plus an extra $100 each month). To the nearest
whole number, what is the number of remaining payments that you must make before the
mortgage is paid off.

Effective monthly rate r = (1.035)
1/6
1 = 0.575004%



6033 . 658 $
00575004 . 1
1
1
.00575004
C
000 , 100

1
1
1 PV
360
1
=
(
(

|
.
|

\
|
=
(
(

|
.
|

\
|
+
=
C
r r
C
T


Amount left after 60 payments have been made
86 . 029 , 94 $
00575004 . 1
1
1
.00575004
658.60

1
1
1 PV
300
60
1
60
=
(
(

|
.
|

\
|
=
(
(

|
.
|

\
|
+
=
PV
r r
C
T

From month 61 the payments will be $758.60 per month
218 55 . 217
00575004 . 1
1
1
.00575004
758.60
86 . 94029

1
1
1 PV
1
or T
r r
C
T
T
=
(
(

|
.
|

\
|
=
(
(

|
.
|

\
|
+
=

Page 10 of 13

QUESTION THREE (15 marks)
Buckeye Books is considering opening a new production facility in Toronto, Ontario. In deciding
whether to proceed with the project, the company has accumulated the following information.

The decision to open the new facility is to some extent based on favourable marketing research.
The research has uncovered that in the next 5 years the Toronto area may account for up to 15%
of Buckeyes entire sales. The research project was completed at a cost of $1 million last year.

The same marketing research suggests that the sales of the companys other production facility in
neighboring Kingston, ON, will drop by $500,000 a year as a result of the new production line in
Toronto as long as the new facility is in operation.

The estimated immediate, up-front cost of constructing the new facility is $10 million. For tax
purposes this facility will be part of a CCA class that depreciates assets at a rate of 15% per year.
Although short on cash, Buckeye plans to raise money for the new facility by issuing $5 million
in debt at a cost of 6%, and $5 million in equity with an estimated cost of 18%.

The company plans to operate the Toronto facility for 5 years. It estimates today that the
facilitys salvage value in 5 years will be $3 million.

If the facility is opened, Buckeye will have to increase its inventory immediately by $2 million,
and by an additional $1 million at the end of each of the first two years. In addition, its accounts
payable will increase immediately by $1 million and by another $1.5 million in one years time.
No further changes of the companys net operating working capital requirements are expected
until the end of the project at which time all net operating working capital increases will be
recovered.

If the new facility is opened, the companys sales will increase by $7 million in the first year.
However, due to high competition, these incremental sales are expected to decline by 2% each
year for the remainder of the projects life. It is assumed that all cash flows will occur at the end
of each year.

The operating costs (excluding CCA) of the new facility are expected to be $3 million in the first
year. Due to rising input costs in this sector of the economy, costs are expected to inflate by 3%
per year over the projects life. It is also assumed that these cash flows will occur at the end of
each year.

The companys tax rate is 40 percent. Buckeyes estimated cost of capital for projects of this
risk is 12 percent.

Buckeye is profitable enough to fully benefit from all CCA deductions.

Required:
Using net present value (NPV) analysis, provide a clear recommendation as to the acceptance or
rejection of the proposed project. Be careful to include only relevant costs in your analysis.
Show all of your work, including formulae used with substitutions.









Leave the rest of this page blank.

Present your answer on the following blank pages.



Page 11 of 13

QUESTION THREE (continued)

PV( initial outlay) = -10,000,000 dollars


PV ( salvage value) = FV/(1+ r)
n
=
5
) 12 . 0 1 (
000 , 000 , 3
+ =
= 1,702,280.567


PV (side effects)
) 4 . 0 1 (
12 . 1
1
1
0.12
500,000 -
Tc) - (1
1
1
1 PV
5
1

(
(

|
.
|

\
|
=
(
(

|
.
|

\
|
+
=
T
r r
C

= -1,081,432.86


PV (Revenues)
) 4 . 0 1 (
12 . 1
98 . 0
1
0.02 0.12
7,000,000
Tc) - (1
1
1
1
5
1

(
(

|
.
|

\
|

+
=
(
(

|
.
|

\
|
+
=
T
r r
C

= 14,612,731.93



PV (Expenses)
) 4 . 0 1 (
12 . 1
03 . 1
1
0.03 0.12
3,000,000 -
Tc) - (1
1
1
1
5
1

(
(

|
.
|

\
|

=
(
(

|
.
|

\
|
+
=
T
r r
C


= -6,843,935.14



PV(changes in NWC)
= + + =
5 2
12 . 1
000 , 500 , 1
12 . 1
000 , 000 , 1
12 . 1
000 , 500
000 , 000 , 1
-499,625.023














PV (CCA Tax Shield)

Page 12 of 13
( ) ( )
n
c n c
k d k
T d S
k d k
T d C
PV
+

+
. \
+

=
1
1

1
2
Shields Tax CCA
k
|
|

|
+ 1





( ) ( )
=
+

+
|
.
|

\
|
+
+
=
5
12 . 1
1
*
15 . 0 12 . 0
4 . 0 * 15 . 0 * 000 , 000 , 3
15 . 0 1
2
15 . 0
1
*
15 . 0 12 . 0
4 . 0 * 15 . 0 * 000 , 000 , 10

= 1,699,010.116



NPV = PV( initial outlay) + PV ( salvage value) +PV (side effects) + PV (Revenues)
+ PV (Expenses) + PV(changes in NWC) + PV (CCA Tax Shield)



Initial Outlay -10,000,000
PV salvage 1,702,280.567
PV side eff -1,081,432.86
PV rev 14,612,731.93
PV exp -6,843,935.14
PV change in NWC -499,625.023
PV CCA 1,699,010.116

NPV -410,970.409

Reject as the NPV is less than zero








Page 13 of 13