The Islamic University - Gaza
Faculty of Commerce
Department of Accounting
Advanced Financial Management
Make up Exam – Second Semester 2011/2012

Please read the following instructions before answering the questions:

(a) Time Allowed for this exam: Two hours

(b) Marks will be granted for neatness and good presentation.

(c)  Marks will be deducted for grammatical and spelling mistakes.

(d) Use the provided answer book for questions No. 4 and 5.

(e)  The use of pencil for writing is not permitted.

(f)  Do not insert any Arabic words in the answer book.

(g) Insert your name and student No. below.

Student Name……………………………………………………

Student No………………………………………………………

Ramadan Al-Omari

May 2012

Question No. 1 (30 Marks)

Choose the correct answer

1. Capital Budgeting is the process of

  1. Raising capital through the issue of long term bonds.
  2. Raising capital through the issue of bonds and ordinary stock.
  3. Identifying, evaluating, and implementing a firm’s investment opportunities.
  4. Ranking projects according to their size.

2. Holders of record are those shareholders whose names are recorded as stockholders on the date of

  1. Declaring the dividends decided by the directors.
  2. Record set by the directors.
  3. Payment of the dividend
  4. Two business days before the date of payment.

3. The maximum acceptable payback period is determined by

a.  Management.

b.  Financial markets.

c.  The project manager.

d.  None of the above.

4. Capital expenditures are long term investments made to

  1. Expand operations.
  2. Replace or renew fixed assets.
  3. Obtain some other, less tangible benefit over a long period.
  4. All of the above.

5. The weighted average cost of capital (WACC) is the

  1. Average cost of the individual sources of capital available to a business entity.
  2. Rate of return that a firm must earn to maintain the market value of its stock.
  3. Rate of return which firms use to evaluate new investment opportunities.
  4. All of the above.

6. The discount rate at which cash flows are discounted in calculating NPV is called

  1. The required return
  2. The cost of capital
  3. Opportunity cost.
  4. All of the above.

7. Exchange rate risk is the risk that an unexpected change in the exchange rate will

a.  Reduce the NPV of a project’s cash inflows.

b.  Reduce the value of a firm’s fixed assets.

c.  Reduce the return on the firm’s cash deposits.

d.  Result in larger payments of interest on the firm’s bonds.

8. According to the constant-payment-ratio dividend policy

  1. Dividends move up and down the earnings.
  2. No dividend is paid when a loss occurs.
  3. The firm pays a fixed percentage of earnings to the owners each period.
  4. All of the above.

9. Independent Projects are those new projects that

  1. Do not compete with the firm’s resources.
  2. Where a firm can select one, or the other, or both.
  3. Projects that usually do not have similar functions.
  4. All of the above.

10. According to the regular dividend policy a firm

  1. Pays a fixed dollar dividend each period.
  2. Increases the amount of dividends each year.
  3. Pays a regular percentage of the earnings.
  4. Is not obliged to pay dividends.

11. Mutually Exclusive Projects are

  1. Investment opportunities that compete in some way for a company’s resources.
  2. Usually not profitable projects.
  3. All projects that could be undertaken in the course of evaluating investments.
  4. All investment opportunities approved by the board of directors.

12. The low-regular-and extra dividend policy the firm pays

  1. A regular dividend amount.
  2. An extra dividend when the firm’s earnings are higher than normal.
  3. A smaller dividend amount when the firm’s earnings are less than normal.
  4. All of the above.

13. The accept-reject approach in capital budgeting means that firms can

a.  Choose between projects without any considerations.

b.  Accept projects that require a lesser amount of capital.

c.  Reject the risky projects regardless of their expected return.

d.  Implement investment opportunities that are evaluated to determine whether they meet the firm’s minimum acceptance criteria.

14. An optimal capital structure is the one that

  1. Has the lowest cost.
  2. Balances the firm’s benefits and costs of debt financing.
  3. Has the highest cost
  4. Consists of equal amounts of debt and equity.

15. Ranking approach in capital budgeting means ranking of projects on the basis of

  1. A predetermined measure, such as the internal rate of return.
  2. Market interest rate.
  3. The amount of working capital needed.
  4. The total cash inflows.

16. The cost of debt financing includes

  1. The probability of bankruptcy.
  2. Agency costs imposed by lenders.
  3. Asymmetric information.
  4. All of the above.

17. Which of the following statements is the incorrect one?

  1. Firms must earn the cost of capital on new projects to maintain equity market value.
  2. The cost of each source of financing is the historical cost of obtaining funds.
  3. Financial risk includes the possibility of being unable to cover interest payments.
  4. Business risk is the possibility of being unable to cover operating costs

18. The Net Present Value (NPV) is found by

a.  Subtracting the initial investment from the total amount of the expected the cash inflows of a project.

b.  Subtracting the present value of the cash outflows from the present value of the cash inflows.

c.  Using a suitable discount rate that would make the NPV equal to zero.

d.  Ranking projects in the order of their payback periods.

19. The Internal Rate of Return (IRR) is the

  1. Market interest rate adjusted for taxes.
  2. Discount rate that will equate the present value of the cash outflows with the present value of the cash inflows.
  3. Interest rate on the specific source of funding used for implementing a project.
  4. Risk free interest rate plus a suitable risk premium.

20. International capital budgeting analysis differs from purely domestic analysis because:

  1. Cash inflows and outflows occur in a foreign currency.
  2. Foreign investments potentially face significant political risks.
  3. Larger amounts of capital are usually needed.
  4. All of the above.

Question No. 2 (20 Marks)

Correct the following false statements

1.  The dividend payment date is the same date as the dividend declaration date.

2.  Investment in new projects will negatively affect a firm’s business risk.

3.  The cost of debt capital and the cost of the preferred stock are similar because both are entitled to receive a fixed income rate.

4.  Preferred stockholders are entitled to receive their dividends before earnings are distributed to bondholders and common stockholders.

5.  Ranking approach in capital budgeting means ranking of new investment opportunities on the basis of their respective size and location.

Question No. 3 (20 Marks)

Give brief answers to the following questions:

(i)  Briefly explain the residual theory of dividend distribution.

(ii)  Briefly explain the “bird-in-the-hand” theory of dividend payment.

(iii)  Explain why the cost of capital in the case of equity is usually higher than that of bonds.

(iv)  Explain the owner considerations that a firm will take into account when deciding on a suitable dividends policy.

(v)  Why would you prefer the net present value technique (NPV) to the pay-back period method when evaluating investment opportunities?

Question No. 4 (20 Marks)

Real Madrid Inc, a European firm, was incorporated in 2009. The Company’s long term capital consists of the following:

  1. 200 5% bonds of a par value of Euro 100 each. They were issued at a discount of Euro 25. Flotation costs amounted to Euro 5 per bond. All the bonds were subscribed for and were fully paid.
  1. 2,000 ordinary stock fully paid up. The par value of each share is Eurp 50. The shares were issued at a premium of Euro 5 each. Flotation costs amounted to Euro 5 per share.
  1. 1,000 10% preferred stock fully paid up. The par value of each share is the same as that of the ordinary stock. The shares, which were issued at par, had a flotation cost of Euro 5 each.
  1. The Company’s current balance sheet shows a Retained Earnings account of Euro 20,000.

In addition, you are given the following additional information:

(i)  Ordinary stockholders expect a dividend of 20% per share at the end of this year and that this is expected to continue for the coming five years.

(ii)  The current risk free interest rate is 4%.

(iii) The market value of the bond currently stands at Euro 105 per bond.

(iv) The ordinary stock is currently traded at Euro 70 each.

(v)  The market value of the preferred stock is Euro 40 each.

You are required to

  1. Calculate the weighted average cost of capital for Real Madrid Inc.
  1. Explain briefly why the market value of the bonds is higher than their par value.
  1. A client of yours is considering investing in Real Madrid Inc. He is seeking your advice as to whether he should buy ordinary stock, preferred stock, or bonds. Explain your answer.

Question No. 5: Mark the following as “True” or “False”. (10 Marks)

a.  The “bird-in-the-hand” argument suggests that investors see current dividends as less risky than future dividends or capital gains.

b.  The residual theory suggests that dividends should be distributed before all acceptable investment opportunities have been undertaken.

c.  The cost of debt capital and the cost of the preferred stock are similar because both are entitled to receive a fixed income rate.

d.  Breakeven analysis measures the level of sales necessary to cover total operating costs.

e.  Business Risk is the risk of a firm being unable to pay dividends for its preferred stockholders.

f.  The cost of capital is the rate of return that a firm must earn on its investments to maintain its market value.

g.  Stock starts to sell ex dividend two business days after the date of record.

h.  According to the dividend non-relevance theory, in a perfect world, the firm’s value is determined solely by its earning power and the risk of its assets.

i.  Independent projects are those projects that can be evaluated, accepted and implemented if the firm has unlimited funds.

j.  Common stockholders find the firm’s retention of earnings acceptable only if they expect that it will earn at least their required return on the reinvested funds.

G O O D L U C K