Download CORPORATE FINANCE 1 FOR IB

EXAM
CORPORATE FINANCE 1 FOR IB
(Course code: 323001)
June 2nd, 2009
SOLUTIONS
Please note the following:
-
This is a closed book examination. The use of a SIMPLE calculator only is allowed.
-
Maximum available time is three hours.
-
There are 30 multiple-choice questions to be answered on the separate computer card. Use
a dark pencil or a pen with black ink. Each multiple-choice question has only one correct
answer; so mark only one box. Wrong answers and answers with more than one box
marked will result in a 0.25 points penalty. Correct answers carry one full point. Blank
answers carry no point and no penalty.
-
Write down the student number and all required information at the appropriate place of
the card.
Hand in the computer card; you can keep your calculation sheets.
Good luck!
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Question 1
Which of the following statements regarding the valuation of an investment project is not
correct?
A) The first step in evaluating a project is to identify the timing of its costs and benefits.
B) In the absence of competitive markets, we can use one-sided prices to determine exact cash
values.
C) Competitive market prices allow us to calculate the value of a decision without worrying
about the tastes/opinions of the decision maker.
D) Because competitive markets exist for most commodities and financial assets, we can use
them to determine cash values and evaluate decisions in most situations.
Answer: B
Explanation: In the absence of competitive markets one sided prices reveal about investor
preferences, not about cash values.
Question 2
If the risk-free rate of interest is 6%, then you should be indifferent between receiving $250 in
one year or:
A) $235.85 today
B) $280.90 in two years
C) $265.00 in two years
D) Both A and C
Answer: D
Explanation:
A) PV(250) = $250.00/1.06 = $235.85
B)
C) FV(250) = $250.00(1.06) = $265.00
D)
Question 3
Consider the following stream of cash flows:
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If the risk-free interest rate is 9%, then the NPV of this stream of cash flows at year 0 is closest
to:
A) $392
B) $389
C) $492
D) $500
Answer: C
Explanation:
PV = 100 /(1.09) + 200 / (1.09)2 + 300 / (1.09)3 = 91.74 + 168.34 + 231.66 = 491.74
Question 4
Suppose that a young couple has just had their first baby and they wish to save enough money to
pay for their child's college education. Currently, the cost of one year of college education is
$12,500 per year. Historically, such cost has increased at an average rate of 4% per year.
Assume they will continue to grow at the same pace.
Assume also that the couple’s savings are invested in an account paying 7% interest, then the
amount of money they will need to have available when the child turns 18 to pay for all four
years of her undergraduate education is closest to:
A) $101,290
B) $107,530
C) $97,110
D) $95,720
Answer: C
Explanation: First, determine the cost of the first year of college:
FV = PV(1 + r)N = $12,500(1.04)18 = $25,322.71
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Then figure out the sum necessary to pay for all four years of college. This is an annuity with
growing payments over four years. Its present value at the beginning of the college period is:
PV = C
1   1 g  
1 

r  g   1  r  
= $25,322.71
  1  .04  4 
1
1 
 = $97,110.01
.07  .04   1  .07  


Question 5
Consider the following investment alternatives, where APR stands for Annual Percentage Rate.
Which alternative offers the highest Annual Effective Rate?
Investment
A
B
C
D
APR
6.25%
6.10%
6.125
6.120
Compounding
Annual
Daily
Quarterly
Monthly
Answer: D
Explanation:
EAR (A) = (1 + APR / k)k - 1 = (1 + .0625) - 1 = .0625
EAR (B) = (1 + APR / k)k - 1 = (1 + .0625/365)365 - 1 = .06289
EAR (C) = (1 + APR / k)k - 1 = (1 + .0625/4)4 - 1 = .06267
EAR (B) = (1 + APR / k)k - 1 = (1 + .0625/12)12 - 1 = .06295
Question 6
On your savings account, you get 9% interest per year (stated annual percentage rate)
compounded monthly. Consider the following two statements.
I: The effective annual interest rate lies between 9.38% and 9.39%
II: If your bank would offer you 9.20% compounded semiannually, you would be better off.
Which of the following is correct?
A) Statement I. is true, statement II. is true.
B) Statement I. is true, Statement II. is false.
C) Statement I. is false, Statement II. is true.
D) Statement I. is false, Statement II. is false.
Answer: A
Explanation:
Statement I. : (1+0.09/12)12 = 1.09381 in EAR terms
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Statement II: (1+0.092/2)2 = 1.09412, in EAR terms with 1.09412 > 1.09381
Question 7
The application of the payback method is not satisfactory because of:
A) It may generate multiple rates of return
B) The existence of sunk costs
C) B and D
D) It ignores the timing of cash flows within the payback period
Answer: D
Explanation: immediate from Chapter 6, section 2.
Question 8
On January 1st, Larry the Cucumber has been offered an upfront payment of €14 million to star in
the lead role of the next three Larry Boy adventure movies. If Larry takes this offer, he will have
to forgo acting in the Toasted Cucumber movie series that would pay him $5 million at the end of
the current and of the next two years. Assume Larry's personal cost of capital is 10% per year.
The NPV of Larry's three movie Larry Boy offer is closest to:
A) 3.5 million
B) -1.6 million
C) 1.6 million
D) -1.0 million
Answer: C
Explanation: NPV = 14 + -5 / (1.10)1 + -5 / (1.10)2 + -5 / (1.10)3 = 1.57
Question 9
Shepard Industries is evaluating a proposal to expand its current distribution facilities.
Management has projected the project will produce the following cash flows for the first two
years (in millions).
Year
Revenues
Operating Expense
Depreciation
Increase in working capital
Capital expenditures
Marginal corporate tax rate
5
1
1200
450
240
60
300
30%
2 1400 525
280 70 350 30% The incremental EBIT for Shepard Industries in year one is closest to (in millions):
A) 360
B) 750
C) 595
D) 510
Answer: D
Explanation: EBIT = Revenues – Op. Expenses – Depreciation = 510
Question 10
Using the information from Question 9, the incremental unlevered net income Shepard Industries
in year one is closest to:
A) 510
B) 415
C) 600
D) 355
Answer: D
Explanation: Incremental Unlevered Net Income = EBIT – Taxation = 357
Question 11
Given the opportunity to invest in one, or more, of the three Treasury bonds listed below, which
bond(s) would you purchase? Each bond has a face value of €1,000.
Bond
A
B
C
Coupon rate
2%
5%
6%
Yield-to-Maturity
2%
4%
6%
A) Bond A
B) Bond B
C) Bond C
D) Both Bond B and Bond C.
Answer: B
Explanation:
Bond A: NPV = 1050(1/0.02)= 1000 = P
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Time-to-Maturity
1 year
18 years
23 years
Market price
$1,000
$1,000
$1,000
Bond B: NPV = 50(1/0.04) (1-1/(1.04)18) + 1000/(1.04)18) = 632.11 + 493.63 = 1125.74 > P
Bond C: NPV = 60(1/0.06) (1-1/(1.06)23) + 1000/(1.06)23) = 649.65 + 261.79 = 911.45 < P
Question 12
If a bond is currently trading at its face (par) value, then it must be the case that :
A)
B)
C)
D)
the bond's yield to maturity is less than its coupon rate.
the bond's yield to maturity is equal to its coupon rate.
the bond's yield to maturity is greater than its coupon rate.
the bond is a zero-coupon bond.
Answer: B
Explanation: from the formula:
Question 13
When discounting dividends you should use?
A) the weighted average cost of capital.
B) the after tax weighted average cost of capital.
C) the equity cost of capital.
D) the before tax cost of debt.
Answer: C
Explanation: discounting dividends requires incorporating the risk premium appopriate for that
stock.
Question 14
You expect HappyEnd Corp. to generate the following free cash flows over the next five years:
Year
FCF (€ millions)
1
25
2
28
3
32
4
37
5 40 Following year five, you estimate that HappyEnd's free cash flows will grow at 5% per year. The
firm’s weighted average cost of capital 13%.
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The enterprise value of HappyEnd is closest to:
A) €396 million
B) €290 million
C) €382 million
D) €350 million
Answer: A
Explanation:
Question 15
Suppose an investment is equally likely to have a 35% return or a –20% return. The Standard
Deviation on the return for this investment is closest to:
A) 0.388
B) 0.194
C) 0.256
D) 0.275
Answer: D
Explanation:
E[R] = .50(35%) + .50(-20%) = 7.5%
Var(R) = .50(.35 - .075)2 + .50(-.20 - .075)2 = 0.07563
SD(R) = (0.07563)½ = 0.275
Question 16
Which of the following statements is false?
A) The expected return is the return that actually occurs over a particular time period.
B) If you hold the stock beyond the date of the first dividend, then to compute you return you
must specify how you invest any dividends you receive in the interim.
C) The average annual return of an investment during some historical period is the simple
average of the realized returns for each year.
D) The realized return is the total return we earn from dividends and capital gains, expressed as a
percentage of the initial stock price.
Answer: A
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Explanation: the expected return is the return that the market expects to occur in the future,
based on all available information. It usually differes from the realized return.
Question 17
Suppose you invest $15,000 in Merck stock and $25,000 in Home Depot stock. You receive an
actual return of -8% for Merck and 12% for Home Depot. What is the actual return on your
portfolio?
A) 4.50%
B) 4.00%
C) We need to know the variance of both stocks to compute the portfolio’s actual return
D) 2.00%
Answer: A
Explanation: Return = (15,000/40,000)(–0.08) + (25,000/40,000)(.12) = .045
Question 18
Consider the following returns:
Year End
2000
2001
2002
2003
2004
2005
Lowes Home Depot Realized Realized Return
Return
20.1%
-14.6%
72.7%
4.3%
-25.7%
-58.1%
56.9%
71.1%
6.7%
17.3%
17.9%
0.9%
IBM Realized Return 0.2% -3.2% -27.0% 27.9% -5.1% -11.3% The Correlation between Lowes' and Home Depot's returns is closest to:
A) 0.58
B) 0.29
C) 0.69
D) 0.10
Answer: C
Explanation:
Year End
Lowes Home Depot Lowes Home Depot Realized Realized Deviation Deviation 9
(RL - RL) × 2000
2001
2002
2003
2004
2005
average =
Return
Return
20.1%
72.7%
-25.7%
56.9%
6.7%
17.9%
24.8%
-14.6%
4.3%
-58.1%
71.1%
17.3%
0.9%
3.5%
Variance =
SD =
(RL - RL)
-4.7%
47.9%
-50.5%
32.1%
-18.1%
-6.9%
(RH - RH)
-18.1%
0.8%
-61.6%
67.6%
13.8%
-2.6%
(RH - RH) 0.00843889 0.00391456 0.31079056 0.21727489 -0.02496211 0.00177389 0.125447467
0.354185639
0.1777954
0.4216579
Covariance =
Correlation =
0.103446 0.692665 Question 19
Which of the following statements is false?
A) If investors have homogeneous expectations, then each investor will identify the same
portfolio as having the highest Sharpe ratio in the economy.
B) Homogeneous expectations are when all investors have the same estimates concerning future
investments and returns.
C) There are many investors in the world, and each must have identical estimates of the
volatilities, correlations, and expected returns of the available securities.
D) The combined portfolio of risky securities of all investors must equal the efficient portfolio.
Answer: C
Explanation: different investors have different expectations of the risk return characteristics of
each security.
Question 20
Tom's portfolio consists solely of an investment in Merck stock. Merck has an expected return of
13% and a volatility of 25%. The market portfolio has an expected return of 12% and a volatility
of 18%. The risk-free rate is 4%. Assume that the CAPM assumptions hold in the market..
Assuming that Tom wants to maintain the current volatility of his portfolio, then the maximum
expected return that Tom could achieve by investing in the market portfolio and risk-free
investment is closest to:
A) 1.39%
B) 15.2%
C) 18.7%
D) To answer the question we need to know how much money Tom can invest .
Answer: B
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Explanation:
SD(RxCML)= xSD(RMkt), therefore 0.25 = x(.18) => x = 0.25/0 .18 = 1.39
E[RxCML] = rf + x(E[RMkt] - rf), therefore E[RxCML] = 0.04 + 1.39(0.12–0.04) = 0.1512
Question 21
Which of the following statements is false?
A) The size effect is the observation that small stocks have positive alphas.
B) When considering portfolios formed based on the market-to-book ratio, most of the portfolios
plot below the security market line.
C) The largest alphas occur in the smallest size deciles.
D) When considering portfolios formed based on size, although the portfolios with the higher
betas yield higher returns, most size portfolios plot above the security market line.
Answer: B
Explanation: When considering portfolios formed based on the market-to-book ratio, most of the
portfolios plot above the security market line.
Question 22
Consider the following information regarding the Fama-French-Carhart (FFC) four factor model:
Factor Portfolio
Rm - rf
SMB
HML
PR1 YR
Average Monthly IBM Factor Return (%)
Betas
0.64
0.17
0.53
0.76
0.712
-0.103
0.124
0.276
Using the FFC four factor model and the historical average monthly returns, the expected
monthly return for IBM is closest to:
A) 0.79%
B) 0.53%
C) 0.71%
D) 2.10%
Answer: C
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Explanation: The return calculation involves multiplying the average monthly return by the
factor beta.
Factor Portfolio
Rm - rf
Average IBM IBM Monthly Factor Return Return (%) Betas
Calc.
SMB
HML
PR1 YR
0.64
0.17
0.53
0.76
0.712
-0.103
0.124
0.276
E[Rs] =
0.456
-0.018
0.066
0.210
0.714
Question 23
Corporate Finance Exam Co has Long Term Debt of €130 million, Short Term borrowing of €60
million, Long Term Assets of €100 million, Cash holding of €70 million and other short term
assets of €38 million. It has 11 million shares outstanding and these shares are trading at €12 per
share, then what is the Enterprise Value of Corporate Finance Exam Co.?
A) €18 million
B) €132 million
C) €252 million
D) €150 million
Answer: C
Explanation: Enterprise value = MVE + Debt - Cash = 11 × $12 + (130+60) - 70 = 252
Question 24
Which of the following is not an operating expense?
A) Interest expense
B) Depreciation and amortization
C) Selling, general and administrative expenses
D) Research and development
Answer: A
Question 25
The following table provides some characteristics of three assets (A, B and a T-Bill) and the
market portfolio.
Asset
expected return
A
14.5%
12
B
19.75%
T-Bill
4.0%
Market portfolio
18.0%
standard-deviation
correlation with the market portfolio
15.0%
0.8
20.0%
0.9
0
0
16.0%
1
What is the expected return for a portfolio ( “portfolio P”) that has a standard deviation of 8.75%
and a correlation of 0.7837 with the market portfolio?
A) 0.12%
B) 0.10%
C) 0.15%
D) None of the above
Answer: D
Explanation: The return is given by the Capital Market Line formula:
E ( rP )  rf 
E ( rm )  rf
m
  P  mp
Where σ indicates a variance and ρ a covariance. Plugging in the information you obtain:
R(RP) = 0.04 + (0.14/0.16)(0.0875)(0.7837) = 0.04 + 0.06 = 0.10 which is equivalent to 10%
Question 26
Calculate the total return of the common stock of Exxxamination Inc. over the last year given that
the capital gain over the year was 9%, the dividend paid during the year was equal to €6 and the
stock price at the end of the year was €70.
A) Total return < 14%
B) 14% ≤ Total return < 16%
C) 16% ≤ Total return < 18%
D) Total return ≥ 18%
Answer: D
Explanation: R(t+1) = (P(t+1) – P(t) + Div(t+1))/P(t). Since (P(t+1)– P(t ))/P(t) = 0.09, it follows
P(t) = 64.2. Then: R(t+1) = 0.09 + 6/(62.2) = 0.1864.
Question 27
This table provides the returns of Cinema Corp. and Beach Inc. in some states of the world.
Probability
0.2
0.5
0.3
State of the weather
rainy
cloudy
sunny
Return Cinema Corp.
30%
20%
10%
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Return Beach Inc.
5%
15%
40%
Consider the following statements:
I. The standard deviation of Cinema Corp. is 32%
II. The covariance between the two stocks is –3.5%
Which of the following is correct?
A) Statement I. is true, statement II. is true.
B) Statement I. is true, Statement II. is false.
C) Statement I. is false, Statement II. is true.
D) Statement I. is false, Statement II. is false.
Answer:D
Explanation: The expected return on Cinema Corp. is 0.19 = 0.2*0.3 + 0.5*0.2 + 0.3*0.1. Its
variance is .1292 = (0.3-0.19)2 + (0.2-0.19)2 + (0.1-0.19)2. The expected return on Beach Inc. is
0.205 = 0.2*0.05 + 0.5*0.15 + 0.3*0.4. The covariance between the two stocks is –.00895 =
0.2(0.3-0.19) (0.05-0.205) + 0.5(0.2-0.19) (0.15-0. 205) + 0.3(0.1-0.19) (0.4-0. 205)).
Question 28
Which of the following statements is false?
A) Because of the Law of One Price, two bonds with the same characteristics, one issued by the
government and one by a listed company, must have the same price.
B) On the day of their issue, the price of a zero coupon bond is lower than the price of a cumcoupon bond, if they are issued on the same day and their maturity is the same.
C) Consider two bonds with the same characteristics, except maturity. The one with longer
maturity will increase its price more if the yield-to-maturity falls.
D) The yield-to-maturity increases when the bond price decreases.
Answer: A
Explanation: a government and a corporate bond are not homegenous investments, since they
have different default risk. Hence their prices will differ.
Question 29
Tilburg SmartWaters traditionally has a dividend payout ratio of 100%. It has earnings per share
of €5 with a cost of capital of 10%. It now has the option of reinvesting its earnings in a
commercialization project that would yield 60 cents for each 10 euros invested, with no effect of
the risk on TSW. The management board of the company decides to invest half of the company’s
earnings in the new project. What is the percentage price change of TSW after the announcement
of this decision?
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A) 14.5%
B) –28.6%
C) –10.4%
D) 15.2%
Answer: B
Explanation: The new project does not change the firm’s cost of capital. The current share price
with a cost of capital of 10% and no growth is P0=50=5/0.1. If TSW invests in the new project, its
earns on it a return of 6%=0.6/10. The growth rate with a retention rate of 50% is
0.03=(0.5)(0.06). Therefore the new share price is: P1=2.5/(0.1–0.03)=2.5/0.07=35.7, where the
dividend is now cut in half to invest in the new project. Therefore the price decreases by €14.3 =
50–35.7, or 0.286=14.3/50 in percentage terms.
Question 30
Which of the following statements is false?
A) Sunk costs should not affect any new investment decision.
B) Project externalities should not be computed as part of the incremental earnings of a new
investment project.
C) When computing the NPV of a new investment project one should compute cash flows for
incremental earnings only.
D) When computing the NPV of a new investment project one should include the opportunity
cost of existing assets used in the project.
Answer: B
Explanation: Project externalities are part of the incremental effects of a new project.
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