LA
GSBA 548 Corporate Finance -- J. K. Dietrich – MBA.PM LA
Final Examination – May 10, 2006
Name______Student No.______Core______
PART I - MULTIPLE CHOICE - WRITE YOUR NAME AND MARK THE BEST ANSWERS ON SCANTRON SHEET. 25 QUESTIONS – 2.2 POINTS EACH - 55 POINTS TOTAL
1) The beta coefficient in the Capital Asset Pricing Model (CAPM) measures
a) systematic risk.
b) unsystematic risk.
c) expected returns.
d) the risk premium over the risk-free rate.
e) all of the above.
2) If markets are efficient,
a) no one makes mistakes.
b) no one loses money.
c) price changes never contain surprises.
d) actual returns always compensate investors for their risks.
e) none of the above.
3) By definition, an efficient portfolio
a) eliminates risk.
b) minimizes risks.
c) includes only risk-free assets
d) includes only a few assets.
e) none of the above.
4) The correlation coefficient between a risk-free and a risky asset
a) is minus one.
b) must be negative.
c) is zero.
d) must be positive.
e) none of the above.
5) The "price of risk" for the market represents
a) the minimum acceptable return for investors.
b) the expected return above the risk-free rate which compensates investors for bearing the average amount of risk in the portfolio of all risky assets.
c) unity for the market portfolio.
d) the standard deviation of the market return.
e) none of the above.
6) In calculating the cash flows from an investment project, the financial analyst must consider all of the following except
a) future tax rates.
b) depreciation charges.
c) investments in working capital.
d) previous sunk costs.
e) future required expenditures on plant and equipment.
7) The present value of a dollar in twenty years discounted at 20 percent is closest to
a) $20.
b) $5.
c) $ .8333.
d) three cents.
e) zero.
8) The present value of a $2.50 perpetuity discounted at 25 percent is
a) $1.
b) $10.
c) $2.
d) $20.
e) cannot be determined with data provided.
9) The value of the first year's cash flow in the above question accounts for
a) UNDER 10 percent of the value of the perpetuity.
b) OVER 20 percent of the value of the perpetuity.
c) half of the value of the perpetuity.
d) a fraction approaching an infinitesimally small number (zero) as the cash flows extend further toward infinity.
e) cannot be determined from the data given.
10) The fraction of the present value accounted for by early cash flows of a project will
a) be larger the lower the discount rate.
b) be larger the higher the discount rate.
c) depend on the pattern of cash flows.
d) not depend on the pattern of cash flows.
e) none of the above.
11) If an investor desired to buy stock in a firm with no debt, that is, an unlevered firm, and create homemade leverage so the stock would be like a firm with leverage, he or she could
a) buy stock in the unlevered firm and bonds in the levered firm.
b) buy stock with borrowed funds.
c) buy more stock in the unlevered firm.
d) sell the stock in the unlevered firm short.
e) not create a position behaving like the levered firm.
12) According to Modigiani and Miller, an rational investor desiring periodic cash payments should buy
a) common stocks paying dividends.
b) preferred stocks.
c) bonds.
d) convertible bonds.
e) the most undervalued financial assets.
13) If a stock priced at $10 pays a $ .50 dividend, half of earnings are retained, and the firm typically yields 20 percent on invested equity, the constant growth estimated cost of equity capital would be
a) 5 percent.
b) 10 percent.
c) 15 percent.
d) 20 percent
e) cannot be determined from data given.
14) An indenture agreement relates to
i) a sales contract.
ii) a long-term union labor contract.
iii) the contract between investment bankers and a client firm.
iv) long-term management contracts entailing severance pay.
v) a borrowing agreement.
Use the following for the next two questions. Stock F has an expected return of 5 percent and a standard deviation of the return of 5 percent. Stock G has an expected return of 10 percent and an standard deviation of 10 percent. The returns on F and G are perfectly correlated. Security F is selling for $100 per share and an investor owns 5000 shares and G is selling for $25 per share and the investor owns 20,000 shares.
15) The portfolio of F and G has an expected return of
a) 5 percent.
b) 7.5 percent.
c) 10 percent.
d) 15 percent.
e) cannot be determined from data provided.
16) The same portfolio of F and G has a standard deviation of
a) 5 percent.
b) 7.5 percent.
c) 10 percent.
d) 15 percent.
e) cannot be determined from data provided.
17) The concept of market efficiency hypothesis in the "weak form" means that market prices reflect all information concerning
a) past prices and trading activity.
b) publicly disclosed and reported information.
c) inside information.
d) future outcomes.
e) all of the above.
18) The concept of market efficiency hypothesis in the "strong form" means that market prices reflect all information INCLUDING concerning
a) past prices and trading activity.
b) publicly disclosed and reported information.
c) inside information.
d) future outcomes.
e) all of the above
19) The following considerations alter the basic Modigliani-Miller arguments concerning the irrelevancy of capital structure except
a) corporate taxes.
b) agency problems.
c) bankruptcy costs.
d) homemade leverage.
e) inefficiencies in capital markets.
20) The after-tax weighted average cost of capital for a firm is appropriate for calculating the present value of a new project except when the
a) risk of the project is the same as the firm’s general risk.
b) capital structure of the firm will be unchanged by financing of the project.
c) project has a different beta than the firm's beta.
d) project has the same asset beta as the firm's assets.
e) project has a negative net present value.
21) In Modigliani and Miller theory with corporate taxes, if the tax rate is 40%, the after-tax cost of debt with an expected yield of 10% is
a) 4%.
b) 6%.
c) 2.5%.
d) determined by the firm’s leverage.
e) Cannot be determined with data given.
22) Market value added and economic value added
a) are unrelated to shareholders’ opportunity costs for invested capital
b) do not account for historical investments in capital.
c) are used to identify the best managed corporations.
d) are more terms in a sequence of mindless management practice and leadership buzzwords.
e) All of the above.
23) If an investor desired to buy stock in a firm with no debt, that is an unlevered firm, which was undervalued and create homemade leverage so that the stock would be like a firm with leverage, he or she could
a) buy stock in the unlevered firm and bonds in the levered firm.
b) buy stock in the unlevered firms with borrowed funds.
c) buy additional stock in the levered firm.
d) sell borrowed stock in the unlevered firm (i.e. sell the unlevered firm short).
e) not create a position behaving like a levered firm with unlevered firm stock.
24) In the absence of corporate taxation , if an unlevered firm has an expected return of 22% and an identical firm financed half of its total assets with debt currently expected to yield 12%, the expected return on the levered firm’s equity is
a) 12%.
b) 17%.
c) 22%.
d) 27%.
e) Cannot be determined from data given.
25) If the correlation coefficient between two assets having standard deviations of returns of 10% and 20% is zero,
a) diversification does not improve the risk-return tradeoffs of a portfolio containing both stocks.
b) a portfolio containing both stocks has a standard deviation proportional to the holdings of the two stocks.
c) it may be possible to have the higher stock’s return with a lower standard deviation by investing in both stocks.
d) it may be possible to earn a higher return on the portfolio with the same risk as the lower risk stock.
e) None of the above.
GSBA 548 Corporate Finance -- J. K. Dietrich – MBA.PM LA
Final Examination – May 10, 2006
Name______Student No.______Core______
PART II - LONGER ANSWERS - WRITE ANSWERS IN SPACE PROVIDED. ANSWER ALL THREE QUESTIONS - 15 POINTS EACH - 45 POINTS TOTAL.
1. Plan a retirement savings program assuming that you wish to retire in 30 years on $100,000 in current dollars; assume that inflation will be 2% a year over your lifetime (in other words, you must adjust your future cash withdrawals for inflation). You expect to earn 12% on your savings and to live 25 years after retiring and (again) want your retirement cash flows to have constant purchasing power. Your savings can grow from the initial level with your annual income that will grow at 5% per year over your 30-year working life.
(a) Calculate how much your first year retirement cash flow must be after accounting for inflation. How much must you have accumulated in 30 years to pay an annual amount with the growing payments offsetting the effects of inflation? Be sure to identify where in your mathematical formulation all the elements of the problem discussed above occur. You will need to use the growing annuity for this analysis.
[4 points]
Inflation is the .02 in the expression, the return on investment is the .12, FV30 is PV30 money needed at time of retirement, $X is annual payment in retirement first year (it grows at 2%).
(b) What level of savings must you begin with next year to accomplish your goals? (I.e. calculate growing savings you will need to fund the answer in (a) above.) You will need to use the growing annuity for this analysis.
[4 points]
where is needed PV0 of payments needed today to produce sum required in 30 years to finance retirement plan in (a) and $Y is annual amount to be saved in first year that will accumulate that sum. In the formula, .05 is growth rate of income and .12 the yield on assets.
(c) In order to achieve your investment objectives, what kind of assets (e.g. small stocks or Treasury bills) would you need to use in your investment portfolio.
[4 points] Using Ibbotson-Sinquefield data in Table 9.2, large stocks have yielded around 12%, small stocks around 17%, and corporate bonds less. The savings should be diversified, but the expected returns will be determined by the combination of asset classes in the retirement portfolio.
(d) What risks do you face from year-to-year in terms of your portfolio value? Your future retirement income? Relate these risks to you choices of investments.
[3 points] Risk in terms of year-to-year variability in portfolio value will be the risk to the saver in terms of variations in liquidation value in case of unexpected cash needs or early retirements, etc., and will be determined by the asset classes, with small-firm stocks the riskiest, Treasury bill the least risky, and so forth. However, returns and risk are directly related.
2. X Corporation and Y Corporation are identical in every way except their capital structures. X in an all-equity firm and has 10,000 shares of stock outstanding worth $50 per share. Y has issued debt that has a market value of $250,000 that is expected to yield 10%. Each firm expects to have an average income of $100,000 in perpetuity but has equal probability of lower income of $50,000 or $150,000 each year. Neither firm pays taxes. Assume that investors can borrow on margin at 10% also. Be sure to make your intermediate steps and reasoning clear and provide all results.
a. What is the expected range and average income on the total equity of X and Y in dollars? [3 points]
Shares in the unlevered corporation have less risk because of the lack of a fixed financial charge.
b. Replicate the expected returns of Y’s total equity using shares of X and margin-account lending. What is the net investment in the X-share position (on a per share basis)? [3 points]
c. Relate the results to part b to the per share value of Y and the total market value of Y including both debt and equity. Describe the role of arbitrage and market equilibrium in requiring this result. [3 points]
Since the net investment in the unlevered Corporation X using margin-account lending is $250,000 and this net position has exactly the same returns and risk as shares in the levered Corporation Y, shares of Y must be worth a total of $250,000. If not, arbitrage profits would be possible by buying the relatively undervalued firm and either replicating the leverage of the unlevered firm as in (b) or unlevering a leveraged firm by buying both its debt and equity.
d. What is the expected return on X and Y shares? Show this result using the results in (b) and with
Modigliani and Miller Proposition II (equation 15.3 in text). [3 points]
Expected return of X = $100,000/$500,000 = 20%, and of Y = $75,000/$250,000 = 30%. Using formula:
e. Briefly, what practical consideration cause departures from the M-M theory? [3 points]
Corporate taxation, bankruptcy risks, costs of financial distress, differences in corporate and personal borrowing rates, market inefficiencies like transaction costs.
3. Use the following data in answering this question: