FIN 515 FINAL EXAM
1. (TCO A) In the United States, which of the following types of organization has the greatest revenue in total?
a. Sole
... [Show More] proprietorship
b. C corporation
c. S corporation
d. Limited partnership
Question 2. (TCO A) Which of the following statements is NOT correct? (Points : 5)
The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends.
The corporate valuation model discounts free cash flows by the required return on equity.
The corporate valuation model can be used to find the value of a division.
An important step in applying the corporate valuation model is forecasting the firm's pro forma financial statements.
Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or terminal, value.
Question 3. (TCO A) Sole proprietorships have all of the following advantages except ?
a. easy to set up.
b. single taxation of income.
c. limited liability.
d. ownership and control are not separated.
Question 4. (TCO B) Which of the following would cause the present value of an annuity to decrease?
a. Reducing the number of payments.
b. Increasing the number of payments.
c. Decreasing the interest rate.
d. Decreasing the liquidity of the payments.
Question 5. (TCO B) In a TVM calculation, if incoming cash flows are positive, outgoing cash flows must be
a. positive.
b. negative.
c. either positive or negative. It really doesn’t matter.
d. stated in time units that are different from the time units in which the interest rates are stated.
Question 6. Which of the following statements is correct? (Points : 5)
One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project’s full life, whereas IRR does not.
One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate.
One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project’s full life, whereas MIRR does not.
One advantage of the NPV over the MIRR method is that NPV discounts cash flows, whereas the MIRR is based on undiscounted cash flows.
Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.
Question 7. (TCO G) The Chadmark Corporation's budgeted monthly sales are $3,000. In the first month, 40% of its customers pay and take the 2% discount. The remaining 60% pay in the month following the sale and don't receive a discount. Chadmark's bad debts are very small and are excluded from this analysis. Purchases for next month's sales are constant each month at $1,500. Other payments for wages, rent, and taxes are constant at $700 per month. Construct a single month's cash budget with the information given. What is the average cash gain or (loss) during a typical month for the Chadmark Corporation?
Answer:
Single Month's Cash Budget for the Chadmark Corporation
Current month sales collected: 3000 x 40% x (100%-2%) = $1176
+ Prior month sales collected: 3000 x 60% = $1800
- purchases $1500
- other expenses $700
= $ 776
Average cash gain during a typical month = $ 776
8. If you were a manager of a company, which of the three right side components of the DuPont Identity would you want to increase and which would you want to decrease, other things being equal? Give a specific example for how to do that for each of the three.
Ans:
The DuPont Identity measures the company’s ROE in terms of its profitability, asset efficiency, and leverage. The model helps investors compare similar companies like these with similar ratios. Investors can then apply perceived risks with each company's business model. Based on these three performances measures i.e. Profit Margin, Total Asset Turnover and Financial Leverage, the model concludes that a company can raise its ROE by maintaining a high profit margin, increasing asset turnover, or leveraging assets more effectively. The first term in the DuPont Identity is the firm’s net profit margin, which measures its overall profitability. The second term is the firm’s asset turnover, which measures how efficiently the firm is utilizing its assets to generate sales. Together, these terms determine the firm’s return on assets. The third term is the equity multiplier which indicates the value of assets held per dollar of shareholder equity. The right side components of the DuPont Identity that can be increased are Net Income and sales. The inventory and account receivable can be reduced which can help the current assets position and in turn reduces total assets, which then improves total asset turnover. I would like to decrease the inefficiencies in asset utilization and inventory holding to improve the ROE. If investors are unsatisfied with a low ROE, the management can use this formula to pinpoint the problem area whether it is a lower profit margin, asset turnover, or poor financial leveraging.
References:
http://www.myaccountingcourse.com/financial-ratios/dupont-analysis
9. (TCO B) Leak Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 11% and FCF is expected to grow at a rate of 5% after Year 2, what is the Year 0 value of operations, in millions? Assume that the ROIC is expected to remain constant in Year 2 and beyond (and do not make any half-year adjustments).
Year: 1 2
Free cash flow: -$50 $100
Answer:
Value of Operations=Present value of the expected free cash flows
Horizon value at year 2= (CF in year 3)/(WACC-G)
Horizon value at year 2 = 100(1.05)/(.11-.05) = 1,750.00
Year Yearly earnings Present value
1 (50.00) (45.05)
2 100.00 81.16
Horizon Value 1,750.00 1,420.34
at Year 2
Net Present value = 1,456.46
10. A stock pays an annual dividend of $2.50 and that dividend is not expected to change. Similar stocks pay a return of 10%. What is P0?
As per the Constant Dividend Growth Model
P0 = Stock Price = Div 1 /( Required Rate of Return – Dividend Growth Rate)
= 2.5 /(0.1 -0) = $ 25
11. A stock has just paid a dividend and has declared an annual dividend of $2.00 to be paid one year from today. The dividend is expected to grow at a 5% annual rate. The return on equity for similar stocks is 12%. What is P0?
Constant Dividend Growth Model
P0 = Stock Price = 2.0 /(0.12 -0.05) = 2.0 /(0.07) = 200/7 = $ 28.57
12. A bond has 5 years to maturity and has a YTM of 8%. Its par value is $1,000. Its semiannual coupons are $50. What is the bonds current market price?
Bonds current market price would be calculated as
Present value of the Face Value =
= 1000 * [ 1/ 1.04 ^10]
= $ 675.564
Present value of the coupon payments
= 50 * [1 - (1/1.04^10)] / 0.04
= $405.54
Bonds current market price = $ 675.564 + $405.54 = $1081.104
13. A bond currently sells for $1,000 and has a par of $1,000. It was issued two years ago and had a maturity of 10 years. The coupon rate is 7% and the interest payments are made semiannually. What is its YTM?
1000 = 35 * 1/y * ( 1- 1/(1 + y)^16) + 1000 /( 1+y)^16
Using Excel Formula
To compute the yield to maturity using excel , we can use the function
=Rate(16,-35,1000,-1000) = 3.5 %
14. A company has 10 million shares outstanding trading for $7 per share. It also has $300 million in outstanding debt. If its equity cost of capital is 15%, and its debt cost of capital is 9%, and its effective corporate tax rate is 40%, what is its weighted average cost of capital?
Fraction of the Company’s value financed by Equity
= 70/370
= 0.189
Fraction of the Company’s value financed by Debt
= 300 /370
= 0.81
Company weighted average cost of capital
= 0.189 * 0.15 + 0.81*0.09 * (1- 0.4)
= 0.189 * 0.15 + 0.81* 0.054
= 0.07209
= 7.209 %
15. Name and describe the three functions of managerial finance. For each, give an example other than those used in the text and lecture.
Managerial finance is concerned with the duties of the financial manager in the business firm. The financial manager actively manages the financial affairs of any type of business, whether private or public, large or small, profit-seeking or not-for-profit. They are also more involved in developing corporate strategy and improving the firm’s competitive position. Managerial finance is concerned with the duties of the financial manager working in a business. Three functions of the managerial finance are listed as below.
Financial Decision - Financial decision is one of the most important functions of the managerial finance. They have to make sound decision about the debt and equity financing for the company. Funds can be acquired through various ways and means. There is an optimal mix of debt and equity for every company and the financing manager has to ensure that a correct ratio of an equity and debt is maintained. This mix of equity capital and debt is known as a firm’s capital structure. The use of debt affects the risk and return of a shareholder. It is more risky though it may increase the return on equity funds. A good capital structure for a company would maximize shareholders return.
Dividend Decision - Earning positive return is a common goal of all the businesses. But the key function a financial manger performs is to decide whether to distribute all the profits to the shareholder or retain all the profits or distribute part of the profits to the shareholder and retain the other half in the business. It’s the financial manager’s responsibility to decide a optimum dividend policy which maximizes the market value of the firm. Hence an optimum dividend payout ratio is calculated. It is a common practice to pay regular dividends in case of profitability. Another way is to issue bonus shares to existing shareholders.
Liquidity Decision - It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s profitability, liquidity and risk all are associated with the investment in current assets. In order to maintain a tradeoff between profitability and liquidity it is important to invest sufficient funds in current assets. Investment in current assets affects firm's profitability and liquidity. More current assets enhance liquidity which helps the firms to meet short-term obligation of the firm. But it also affects the profitability negatively as the current assets earn much less than their cost of capital. Financial manager needs to carry out a trade-off between liquidity and profitability while balancing investment in current assets.
References:
http://www.managementstudyguide.com/finance-functions.htm
16. Explain thoroughly how stock portfolios affect the risk to an investor.
Ans:
A portfolio consists of a number of different securities or other assets selected for investment gains. However, a portfolio also has investment risks. The primary objective of portfolio theory or management is to maximize gains while reducing diversifiable risk. Portfolios can consist of any number of assets with differing proportions of each asset, there is a wide range of risk-return ratios. By selecting the right assets in the right proportions, it may be possible to reduce diversifiable risk to near zero, but the portfolio would still have systematic risk, which also affects the general market. Portfolios, like stocks, have betas which measure the systematic risk of the portfolio compared to that of the market. Most investors try to reduce the risk associated with an individual stock by diversification. Investors want to minimize the risk associated with a given firm's expected return. Diversification can play a role by minimizing firm-specific risks. Fluctuations of a stock’s return that are due to firm-specific news are independent risks. This type of risk is also referred to as firm-specific risk. Fluctuations of a stock’s return that are due to market-wide news represent common risk. This type of risk is also called systematic, undiversifiable, or market risk. When we combine many stocks in a large portfolio, the firm-specific risks for each stock will average out and be diversified. Good news will affect some stocks, and bad news will affect others, but the amount of good or bad news overall will be relatively constant. When firms carry both types of risk, only the firm-specific risk will be diversified when we combine many firms’ stocks into a portfolio. The volatility will therefore decline until only the systematic risk. When we are adding new assets to the portfolio, we are actually lowering the variability of returns. Through careful selection of assets in the portfolio, we can eliminate most firm-specific risk. By owning a portfolio of stocks, it's possible to lower the overall risk of the entire investment portfolio.
References: http://thismatter.com/money/investments/modern-portfolio-theory.htm
Berk, Jonathan B., Peter DeMarzo. 1962. Corporate finance. 3rd ed. Peterson Publishing.
17. What is the Cash Conversion Cycle (CCC)? Name the components of the CCC and explain why the CCC is important to business.
Answer:
The cash conversion cycle measures the number of days the firm's operating cycle requires costly financing to support it. You can think of the operating cycle as the number of days sales invested in inventories and receivables. Cash conversion cycle (CCC) has been considered a useful measure of firm’s effective working capital management and especially the cash management.
The CCC days are calculated by taking into account the
1. Debtors turnover period,
2. Payables turnover period, and
3. Inventory turnover period.
The CCC length in days can be simply calculated as follows:
CCC days = inventory turnover days + debtors turnover days – payables turnover days
The reduction in cash conversion cycle (CCC) can help the firms to increase its working capital and improve its cash position. If a company wants to shorten their CCC, there are three steps they can take. They can decrease their Inventory Conversion Period, which is shortening the time it takes to convert inventories into accounts receivable such as by implementing a just in time inventory management system, Another way is to reduce the Average Collection Period, which is the amount of time the company's customers take to pay for the goods. This is usually accomplished by instituting a small discount for payments made promptly. The third way is to increase the Payables Deferral Period, which is to extend the time it takes for the company to pay its suppliers. Firm can use their relationship with suppliers to create faster turnaround on cash flow cycle. Also firm can do this by getting their suppliers to accept a longer debt repayment period than what is normal in accounts receivable relationships. Rather than having a 30 or 60 days repayment period, getting the creditors to extend the repayment period beyond that will allow to have more cash on hand without having to pay creditors as often. Existing relationship can be used with customers to eliminate the time between cash flow cycles.
18. A company has the opportunity to do any of the projects for which the net cash flows per year are shown below. The company has a cost of capital of 12%. Which should the company do and why? You must use at least two capital budgeting methods. Show your work.
Year A B C
0 -300 -100 -300
1 100 -50 100
2 100 100 100
3 100 100 100
4 100 100 100
5 100 100 100
6 100 100 100
7 -100 -200 0
(Points : 40)
Ans:
1st Capital Budgeting Method ( NPV Calculation)
Project ‘A’ NPV -
Year Net Cash Flow Discount Rate Discounted Amount
0 -300 -300
1 100 1.12 89.28
2 100 1.2544 79.72
3 100 1.404928 71.18
4 100 1.573519 63.55
5 100 1.762342 56.74
6 100 1.973823 50.66
7 -100 2.210681 -45.23
NPV 65.91
Project ‘B’ NPV -
Year Net Cash Flow Discount Rate Discounted Amount
0 -100 -100
1 -50 1.12 -44.64
2 100 1.2544 79.72
3 100 1.404928 71.18
4 100 1.57351936 63.55
5 100 1.762341683 56.74
6 100 1.973822685 50.66
7 -200 2.210681407 -90.47
NPV 86.74
Project ‘C ‘ NPV
Year Net Cash Flow Discount Rate Discounted Amount
0 -300 -300
1 100 1.12 89.28
2 100 1.2544 79.72
3 100 1.404928 71.18
4 100 1.57351936 63.55
5 100 1.762341683 56.74
6 100 1.973822685 50.66
7 0 2.210681407 0
PV 111.14
The company should do the project ‘C’ as the Net present value of the discounted cash flow is the highest which is $ 111.14.
2nd Capital Budgeting Method ( Cash Payback Period)
Project 'A'
Year Net Cash Flow Cumulative Cash Flow
0 -300 -300
1 100 -200
2 100 -100
3 100 0
4 100 100
5 100 200
6 100 300
7 -100 200
Cash payback period
3 Years
Project 'B'
Year Net Cash Flow Cumulative Cash Flow
0 -100 -100
1 -50 -150
2 100 -50
3 100 50
4 100 150
5 100 250
6 100 350
7 -200 150
Cash payback period
2.5 Years
Project 'C'
Year Net Cash Flow Cumulative Cash Flow
0 -300 -300
1 100 -200
2 100 -100
3 100 0
4 100 100
5 100 200
6 100 300
7 0 300
Cash payback period
3 Years
As per the Cash Payback period technique, this is better for the firm to carry out the Project ‘B’ as the cash be recovered faster and company can recover the initial investment much sooner. [Show Less]