Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and
Joel F. Houston (Dryden, 1998). Study Session 11, 2003, An Overview of
Financial ...
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Study Session 11 Sample questions Asset Valuation Corporate Finance 1A
An Overview of Financial Management
1.
In a hostile takeover situation, managers have a strong incentive to: A. B. C. D.
take actions designed to minimize stock prices because the managers of the acquired firm are generally fired, and any who stay on lose status and authority take actions designed to maximize stock prices because the managers of the acquired firm are generally fired, and any who stay on lose status and authority buy stock at a stated price within a specific time period sell stock at a stated price within a specific time period
Answer B. Agency problems and a hostile takeover In a hostile takeover situation, managers have a strong incentive to take actions designed to maximize stock prices because the managers of the acquired firm are generally fired, and any who stay on lose status and authority Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, An Overview of Financial Management, Los 1A,a
Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
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An agency problem between creditors and stockholders may arise when: A. B. C. D.
a firm takes on a large new project that is far riskier than was anticipated by stockholders managers lend additional funds and use the proceeds to repurchase some of the firm’s outstanding stock managers borrow additional funds and use the proceeds to repurchase some of the firm’s preference stock managers borrow additional funds and use the proceeds to repurchase some of the firm’s outstanding stock
Answer D. Agency problems between creditors and stockholders An agency problem between creditors and stockholders may arise when managers borrow additional funds and use the proceeds to repurchase some of the firm’s outstanding stock. Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, An Overview of Financial Management, Los 1A,a
Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
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B.
The Cost of Capital
1.
Assume the following information relating to Mod Company: Borrowing rate Tax rate Preferred dividend per share Market price of preference shares Floatation costs on preference shares Risk free rate Market rate Beta Stock price Expected dividend Floatation costs on new shares
10% 40% $10 $100 2.5% 8% 13% 0.7 $23 $1.24 10%
Determine the cost of debt A. B. C. D.
3% 4% 6% 5%
Answer C. Calculating the cost of debt The cost of debt is 6% Cost of debt = kd (1-T) = 0.1(1-0.4) = 6% Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, The Cost of Capital, Los 1B,b Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
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Which of the following factors affecting the cost of capital can a firm control? I. II. III. IV. V.
Capital structure policy Dividend policy Investment policy Interest rates Tax rates
A. B. C. D.
I only I and II only I, II and III IV and V only
Answer C. Factors affecting the cost of capital that a firm can control Factors affecting the cost of capital that can be controlled by a firm include: • Capital structure policy • Dividend policy • Investment policy Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, The Cost of Capital, Los 1B,g
Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
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C.
The Basics of Capital Budgeting
1.
Project X has a cost of $156,375, its expected net cash inflows are $36,000 per year for 8 years, and its cost of capital is 14 percent. The project's payback period (to the closest year) is? A. B. C. D.
4 years 3 years 2 years 1 year
Answer A. Calculating payback period The project's payback period (to the closest year) is 4 years. $156,375/36,000 = 4.34 years Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, The Basics of Capital Budgeting, Los 1C,b
Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
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D.
Cash Flow Estimation and Other Topics in Capital Budgeting including Appendix 11A
1.
Consider the following information: A machine was purchased 10 years ago at a cost of $15,000. The expected life of the machine was 15 years. Its salvage value was and is still zero. The machine is depreciated using the straight-line basis. A new machine can be purchased for $24,000, which will result in cost savings for the firm of $6,000 per annum over the 5 year useful life. The new machine can be sold for $4,000 in 5 years time. The old machine’s market value is $2,000, which is below its $5,000 book value. If the new machine is purchased, the old one will be sold. The tax rate is 40%. Net working capital requirements will increase by $2,000 at the time of replacement. The new machine falls into the 3-year MACRS class. The cost of capital is 11.5%. The NPV and decision of the replacement project is: A. B. C. D.
$765.77 and accept since NPV is positive $987.33 and accept since NPV is positive -$564.55 and reject since NPV is negative -$777.55 and reject since NPV is negative
Answer D. Determining NPV and making a decision The NPV and decision of the replacement project is -$777.55 and reject since NPV is negative.
Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
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Year 0 Investment outlay 1. 2. 3. 4. 5.
Cost of new equipment Market value of old equipment Tax savings on old equipment1 Increase in net working capital Total net investment
(24,000) 2,000 1,200 (2,000) (22,800)
Operating inflows over the Project’s Life 1 6. 7. 8. 9. 10. 11.
After-tax decrease in costs2 Depreciation on new machine3 Depreciation on old machine Change in depreciation Tax savings from depreciation Net operating cash flows (6 + 10)
2
3
4
5
3,600 3,600 3,600 3,600 3,600 7,920 10,800 3,600 1,680 0 1,000 1,000 1,000 1,000 1,000 6,920 9,800 2,600 680 (1,000) 2,768 3,920 1,040 272 (400) 6,368 7,520 4,640 3,872 3,200
Terminal Year Cash Flows 12. 13. 14. 15.
Estimated salvage value of new machine Tax on salvage value Return of net working capital Total termination cash flows
4,000 (1,600) 2,000 4,400
Net Cash flows 0 16.
1
2
3
4
5
Net cash flow time line (22,800) 6,368 7,520 4,640 3,872 7,6004
Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
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Results Using the Texas instruments 2nd CLR WORK 2nd RESET ENTER CF 22,800 ± ENTER ↓ 6,368 ENTER ↓ ↓ 7,520 ENTER ↓ ↓ 4,640 ENTER ↓ ↓ 3,872 ENTER ↓ ↓ 7,600 ENTER NPV 11.5 ENTER ↓ CPT NPV = -$777.55 Reject Workings: 1.
Loss = 3,000 Tax rate 40% 3,000 x 40% = 1,200
2.
Reduction in costs = Increase in tax Increase in after tax cash flows
3.
MACRS depreciation = 24,000 x 0.33 = 7,920 24,000 x 0.45 = 10,800 24,000 x 0.15 = 3,600 24,000 x 0,07 = 1,680
4.
3,200 + 4,400 = 7,600
Study Session 11 Sample Questions
6,000 2,400 3,600
Asset Valuation: Corporate Finance
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Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, Cash Flow Estimation and Other Topics in Capital Budgeting, Los 1D,d 2.
Consider the following information: A firm estimates annual sales of $20 million. To achieve this the firm will need to buy a building at a cost of $6 million, which would be bought and paid for in one year on December 31, 2000. It will fall into the MACRS 39 –year class. New equipment would also be purchased for $4 million and would fall into the MACRS 5-year class. It would also be paid for on December 31, 2000. The project also requires an investment of $3 million in net working capital, made available on December 31, 2000. The project’s estimated life is 4 years and at that time the building is estimated to have a market value of $3.75 million and a book value of $5.454 million. The equipment will have a market and book value of $1 million and $0.68 million respectively. Variable manufacturing costs will be 60% of sales and fixed overheads will be $2.5 million excluding depreciation. The tax rate is 40%. The cost of capital is 12%. The initial investment outlay is: A. B. C. D.
($13) million ($12) million ($6) million ($10) million
Answer A.
Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
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Determining the initial investment outlay Investment outlay Building Equipment Increase in net working capital Total
(6,000,000) (4,000,000) (3,000,000) (13,000,000)
Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, Cash Flow Estimation and Other Topics in Capital Budgeting, Los 1D,e
E.
Risk Analysis and the Optimal Capital Budget
1.
Market, or beta risk can be described as: A. B. C. D.
that part of a project’s risk that cannot be eliminated by diversification; it is measured by the project’s beta coefficient risk not considering the effects of stockholders’ diversification; it is measured by a project’s effect on uncertainty about the firm’s future earnings the risk an asset would have if it were a firm’s only asset and if investors owned only one stock. It is measured by the variability of the asset’s expected returns that part of a project’s risk that can be eliminated by diversification; it is measured by the project’s beta coefficient
Answer A.
Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
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Market or beta risk Market, or beta risk can be described as that part of a project’s risk that cannot be eliminated by diversification; it is measured by the project’s beta coefficient. Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, Risk Analysis and the Optimal Capital Budget, Los 1E,a 2.
The Risk-Adjusted Discount Rate can be described as: A. B. C. D.
the discount rate that applies to a particular risky stream of income; the riskier the project’s income stream, the lower the discount rate the discount rate that applies to a non risky stream of income the discount rate that applies to a particular risky stream of income; the riskier the project’s income stream, the higher the discount rate the discount rate that applies to a non-risky stream of income; the less risky the project’s income stream, the higher the discount rate
Answer C. The Risk-Adjusted Discount Rate The Risk-Adjusted Discount Rate can be described as the discount rate that applies to a particular risky stream of income; the riskier the project’s income stream, the higher the discount rate.
Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
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Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, Risk Analysis and the Optimal Capital Budget, Los 1E,e
F.
Capital Structure and Leverage
1.
Consider the following information about a company that borrows funds: Interest rates for Mod Company with different debt/assets ratios Amount borrowed 30,000 60,000 90,000 120,000 150,000 180,000
Debt/assets ratio 20% 30 40 50 60 70
Interest rate of all debt 9.0% 9.5 11 12 14 16
The firm must borrow in increments of $30,000 and is unable to borrow more than $180,000 EBIT at different levels of sales Scenario Probability of indicated sales Sales Fixed costs Variable costs Total costs Earnings before interest and taxes
A 0.1 200,000 60,000 140,000 200,000 $ 0.0
B 0.5 300,000 60,000 210,000 270,000 30,000
C 0.4 400,000 60,000 280,000 340,000 60,000
Assume the company has 20,000 issued shares. The tax rate is 40%.
Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
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At a sales level of $300,000, the degree of operating leverage is equal to: A. B. C. D.
2.0 1.0 3.0 undefined
Answer C. At a sales level of $300,000, the degree of operating leverage is equal to 3.0 Calculating the degree of operating leverage
∆ S − VC = EBIT = DOL = ∆Q S − VC − F Q 300,000 − 210,000 90,000 = = = 3.0 300,000 − 210,000 − 60,000 30,000 Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, Capital Structure and Leverage, Los 1F,h
Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
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Financial leverage refers to the use of fixed-income securities whereas financial risk is:
A. B. C. D.
the additional risk placed on the common stockholders as a result of financial leverage the additional risk placed on the common stockholders as a result of operating leverage the reduction in risk as a result of financial leverage the reduction in risk as a result of operating leverage
Answer A. Financial leverage Financial leverage refers to the use of fixed-income securities whereas financial risk is the additional risk placed on the common stockholders as a result of financial leverage. Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, Capital Structure and Leverage, Los 1 F,g
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Asset Valuation: Corporate Finance
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G.
Dividend Policy
1.
Jessica Ltd has net income of $3,000,000 and it has 2,000,000 shares of common stock outstanding. The company’s stock currently trades at $45 a share. Jessica is considering a plan where it will use available cash to repurchase 30 percent of its shares in the open market. The repurchase is expected to have no effect on either net income or the company’s P/E ratio. The stock price following the stock repurchase will be: A. B. C. D.
$64.29 $45.00 $76.67 $50.00
Answer A.
Stock repurchases and the price effect The stock price following the stock repurchase will be $64.29 Repurchase = 0.3 x 2,000,000 = 600,000 shares Repurchase amount = 600,000 x $45 = $27 million EPS old = 3,000,000/2,000,000 = 1.50 P/E = 45/1.50 = 30x EPS new = 3,000,000/1,400,000 = 2.14 Price new = EPS new x P/E = 2.14 x 30 = $64.29 Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, Dividend Policy, Los 1 1G,k
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Asset Valuation: Corporate Finance
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In 2002 the Bari Company paid dividends totalling $2,700,000 on net income of $8.5 million. For the past 10 years, earnings have grown at a constant rate of 12 percent. In 2003, earnings are expected to jump to $12.5 million, and the firm expects to have profitable investment opportunities of $6.5 million. It is predicted that Bari will not be able to maintain the 2003 level of earnings growth and the company will return to its previous 12 percent growth rate. Bari’s target debt ratio is 50 percent. Assume that investors expect Bari to pay total dividends of $7,500,000 in 2003 and to have the dividend grow at 12 percent after 2003. The stock's total market value is $150 million. The long-run average return on equity of Bari is: A. B. C. D.
19% 18% 20% 21%
Answer B.
Calculating the return on equity The long-run average return on equity of Bari is 18% g = b(ROE) 0.12 = (1 – 2,700,000/8,500,000) (ROE) ROE = 0.12/0.68 = 0.18 = 18% Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, Dividend Policy, Los 1 1G,e
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Asset Valuation: Corporate Finance
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Discounted Cash Flow Applications Use the following information in answering Questions 1 - 2 The Mod corporation is planning to spend $15 million on a marketing campaign. The company expects this expenditure to result in annual incremental cash flows of $2.3 million in perpetuity. The cost of capital is 10%.
1.
The NPV for the planned marketing campaign is: A. B. C. D.
$15,000,000 $23,000,000 $8,000,000 -$15,000,000
Answer C.
Determining the NPV The NPV for the planned marketing campaign is $8,000,000 NPV = -$15,000,000 + 2,300,000/0.10 = -$15,000,000 + 23,000,000 = $8,000,000 Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, Discounted Cash Flow Applications, Los 1 2a
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The IRR is: A. B. C. D.
15.33% 16.33% 17.67% 14.67%
Answer D.
Determining the IRR The IRR is 14.67% Initial investment = Annual cash inflow/IRR 15,000,000 = 2,300,000/IRR IRR = 2.3/15 = 15.33% Reference Fundamentals of Financial Management, 8th edition, Eugene F. Brigham and Joel F. Houston (Dryden, 1998) Study Session 11, 2003, Discounted Cash Flow Applications, Los 1 2a
Study Session 11 Sample Questions
Asset Valuation: Corporate Finance
