MGT201 Financial Management Subjective Questions Answers for Midterm Exam Preparation

MGT201 Financial Management Subjective Questions Answers For Midterm Exam Preparation

Suppose ABC Company is given Rs. 3 as dividend which is expected to grow at constant rate of 9% per year from now on. What would be the stock price of company if the required rate return is 17%? (3 Marks :)

EXPECTED RATE OF RETURN mark 5

Probability / Return
25% / 12%
25% / 11.50
25% / 10
25% / 9.50

Answer .1075 or 10.75

Slandered Deviation?

Correlation / 1.8
Return on asset z / 20%
Slandered deviation of z ?

Answer 63 % (

=sqrt

Rs 63 , Rs 36 , 36 %

10 Year bond with 12% coupon rate is selling at Rs. 1650 face value of bond is Rs. 1000. Required rate of return is 14%. SEMI ANUALLY.

=FV/(1+ror%/M)^20

=1435

Differentiate the Floating rate bond and junk bound

Floating Rate Bond:

It is defined as a type of bond bearing a yield that may rise and fall within a specified range

according to fluctuations in the market. The bond has been used in the housing bond market

Eurobonds: it issued from a foreign country

Junk Bonds & High Yield Bonds: Corporations that are small in size, or lack an established operating

track record are also likely to be considered speculative grade. Junk bonds are most commonly

associated with corporate issuers. They are high-risk debt with rating below BB by S&P

H Corporation’s stock currently sells for Rs.20 a share. The stock just paid a dividend of Rs.2 a share (Do = Rs.2). The dividend is expected to grow at a constant rate of 11% a year. What stock price is expected 1 year from now?

Stock Price= div+price/(1-g)

Briefly explain what call provision is and in which case companies use this option. (3 marks)

The right (or option) of the Issuer to call back (redeem) or retire the bond by paying-off the Bondholders before the Maturity Date. When market interest rates drop, Issuers (or Borrowers) often call back the old bonds and issue new ones at lower interest rates

Suppose you approach a bank for getting loan. And the bank offers to lend you Rs.1, 000,000 and you sign a bond paper. The bank asks you to issue a bond in their favor on the following terms required by the bank: Par Value = Rs 1, 000,000, Maturity = 3 years
Coupon Rate = 15% p.a, Security = Machinery
You are required to calculate the cash flow of the bank which you will pay every month as well as the present value of this option. (5 marks)

Data:

Par Value = Rs 1, 000,000

Maturity = 3 years

Coupon Rate = 15% p.a,

Security = Machinery

Solution:

CF = Cash Flow = Coupon Value = Coupon Rate x Par Value

CF = 15% x 1,000,000

CF = 150000/12

Monthly CF = 12500

Assume that rD = 10%

PV = CF1/(1+rD/12)12+CFn/(1+rD/12)2x12 +..+CFn/ (1+rD/12) n +PAR/ (1+rD) n

PV = 12500/ (1 + 0.10/12)12 + 12500/ (1 + 0.10/12)2x12 + 12500/ (1 + 0.10/12)3x12 + 1000000/(1 + 0.10/12)3x12

PV = 12500/ (1.00833)12 + 12500/ (1.00833)24 + 12500/ (1.00833)36 + 1000000/(1.00833)36

PV = 11315.60425 + 10243.43196 + 9272.849775 + 741828

PV = 772660

FV = CCF (1 + rD/m )nxm - 1/rD/m

FV = 12500 (1 + 10%/12)3x12 - 1 / 10%/12

FV = 12500 (41.779)

FV = 522237.5

PV (Coupons Annuity) = FV / (1 + rD/m) nxm

PV = 522237.5/(1 + 10%/12) 3x12

PV = 522237.5/1.348021407

PV = 387410

PV (Par) = 1,000,000 / (1.00833)36

PV (Par) = 741828

PV = PV (Coupons Annuity) + PV (Par)

PV = 387410 + 741828

PV = 1129238

A security analyst has estimated the following returns on the stocks of 4 large companies:

Weight age Expected Returns

Company A 25% 12%
CompanyB 25% 11.5%
CompanyC 25% 10%
Company D 25% 9.5%

You are required to calculate the expected return on this portfolio. (5 marks)

rP * = rA xA + rB xB+rC xB+rD xD

= 12% (25/100) + 11.5 %( 25/100) + 10%(/25/100) + 9.5%(25/100)

= 3% + 2.8757% + 2.5 + 2.375

= 10.75%

5 Marks: Suppose Govt. pay coupon on its bond quarterly; calculate the intrinsic value of bond under following circumstances: 10 Year bond with 10% coupon rate is selling at Rs. 1050 face value of bond is Rs. 1000. Required rate of return is 12%.

Suppose there are 2 stocks in your investment portfolio,

Value of investment / Expected IRR
A / 40 / 30
B / 60 / 20
Total / 100

Calculate the expected portfolio return

Solution:

Expected Portfolio return calculation:

rP = rA x A + rB x B

rP = 30% x (40 / 100) + 20% x (60 / 100)

rP = 0.12 + 0.12

rP = 0.24 or 24%

Why the companies prefer to raise money through debt not through equity? (3 Marks)

Debt financing refers to any borrowed money which the entrepreneur must pay back to the lending institution. An interest rate and other terms apply. Company which are well established and profitable growth often rely on debt financing.

Equity financing is money lent in exchange for ownership in a company. New businesses can use equity financing for their startups or when they need to raise additional equity capital to offset existing debt. REASON

The debt finance company is not interested in becoming a partner in your endeavor, instead they are in business to make money from their money, letting you use it for periods of time. When seeking outside capital, whether equity or debt, remember that certain sources are familiar and like to work with particular industries. Take the time to look around and be sure that the source you are considering is well-aquatinted with your type of business.

What is the relationship between standard deviation & Risk (3 Marks)

The standard deviation is a direct measure of risk involved in the purchase of the share. The more the standard deviation, the more the stock is considered to be risky. Standard deviation is commonly used as a measure to compare two or more set of data. The price of two stocks can have same mean, but they will have different standard deviation. The stock with larger standard deviation is considered to be more risky than the stock having smaller standard deviation, because it has more variability in its mean price.

However, we should also calculate the range of data for the two stocks to make our conclusion more stronger. The range is calculated as

Range = Highest value - Lowest value.

The stock having small range is considered to be less risky than the stock with larger range.

Risk means the chance of actual outcome differing from expected outcome. Higher risk tends to result in a lower share price as shareholders demand more compensation for the greater risk in the form of higher expected returns. In nutshell, the stock having small standard deviation and range is considered as less risky than the stocks having larger standard deviation and range.

1- Company ABC wants to issue more common stock face value Rs.10. Next year the Dividend is expected to be Rs.2 per share assuming a Dividend growth rate of 10%pa. The lawyers’ fee and stock broker commission will cost Rs.1 per share. Investors are confident about company ABC so the common share is floated at market price of Rs.16 (i.e. Premium of Rs.6). If the capital structure of company ABC is entering common equity then what is the company WACC? Use Retained Earning Approach to calculate the result. (Marks=5)

Calculate Required ROR for Common Stock using Gordon’s Formula

r = (DIV1/Po) + g

Po = market price = 16

Div1 = Next Dividend = 2

G = growth rate = 10%

r = (2/16)+10% = 22.50%

Now If company wanted to issue the stock via new float then it has to pay the lawyer fee and broker commission which 1 Rs.

Net proceed = 16 – 1 = 15

r = (2/15)+10% = 22.50% = 23.33%

Find the Beta on a stock given that its expected Return is 16% the Risk free rate is 4% and the Expected return on the Market portfolio is 12% (Marks 5)

r = rRF + Beta (rM - rRF).

r=16%

Rf=4%

rM=12%

B=?

16% = 4% + Beta (12% - 4%).

16%-4%=Beta*8%

12%/8%=Beta

1.5=Beta

Risk free Rate is 15% and expected Market Return is 20%. FM Corporation has a bet of 1.9 and Gold Corporation has beta of 1.5. Find Expected Return on FM Corporation and Gold Corporation.

r = rRF + Beta (rM - rRF).

B=1.9

rM=20%

rRF=15%

r=15%+1.9(5%)

Gold Company:

B=1.5

rM=20%

rRF=15%

r = rRF + Beta (rM - rRF).

r=15%+1.5(5%)

EBIT of a firm is Rs. 200 and corporate tax rate, Tc is 30 %. If the firm is 100% Equity and rE is 20%. Then calculate WACC.

WACC = rD XD. + rP XP + rE XE .

WACC=0+0+20%(100)

WACC=20%

Explain the equation of EBIT when it is equal to Break Even Point. MARKS-5

An indicator of a company's profitability, calculated as revenue minus expenses, excluding tax and interest. EBIT is also referred to as "operating earnings", "operating profit" and "operating income", as you can re-arrange the formula to be calculated as follows:

EBIT = Revenue - Operating Expenses

Also known as Profit before Interest & Taxes (PBIT), and equals Net Income with interest and taxes added back to it.

Breakeven Point: Quantity of Sales at which EBIT = 0

EBIT = Op Revenue - Op Costs = Op Revenue - Variable Costs – Fixed Costs

= PQ - VQ - F. Where P= Product Price (Rs), Q= Quantity

#Units Sold, V= Variable Cost (Rs), F= Fixed Cost (Rs). So IF EBIT = 0

then PQ-VQ-F = 0 so Breakeven Q = F / (P - V)

Calculate the market value of equity for a 100% equity firm using the following information extracted from its financial statements: EBIT = Rs. 50, 000, return on equity is 12%, amount of equity is Rs. 100, 000. tax rate is 35%.

First all all we net to calculate Net income

Net income = EBIT – Interest – tax

Net income = 50,000 – 0 – (.35* 50,000) = 32,500

Now to calculate the market value of firm

Net income/ return on equity

= 32500/.12 = 270833.3

Market value of unleveraged firm (100% equity firm) equity + debit

= 270833.3 + 0

= 270833

Earnings before interest and taxes (EBIT) of Firm is Rs.1000 and Corporate Tax Rate, Tc is 30%

If the Firm is 100% Equity (or Un-Levered) and rE = 30% then what is the WACCU of Un-levered Firm?

1) Net income = EBIT - I - Tax

= 1000 - 0 - 30% (0.3)

= 700

2) Equity (Un-L) = NI/Re

= 700/30% (0.3)

= 2334

3) WACC(Un-L) = Equity + Debt

= 2334 + 0 So

= 2334 Here is note that wacc is equal to equity

= 30% Jitna equity k rate hoga otahi WACC ho of Un-levered firm.....

If the Firm takes Rs.1000 Debt at 10% Interest or Mark-up then what is the WACCL of Levered Firm? (There is no change in return in equity)

1)Net income = EBIT - I - Tax

= 1000 - .1(1000) - 30% (900)

2) Equity (Un-L) = NI/Re

= 630/30% (0.3)

= 2100

3)WACC (L) = Equity + Debt

= 2100 + 1000

= 3100

Formula:...

WACC = Rd*(1 - tc)Xd + Re*Xe

= .1*(1 - 0.3)*(1000/3100) + 0.3*(2100/3100)

= 0.225806

= 22.5806%

100% Equity (un – levered) firm as total Assets of Rs. 50000 weighted average cost of capital for an un – levered firm (WACCU) is 35% and cost of debt for un – levered firm (r d u ) of 20% it then adds Rs. 20000 of debt financial Risk increases cost of debts (r d L) of leverd Firm to 18% (Marks 5)

Required

What is levered firms Cost of equity (r e L)?

What will be the WACC L of levered Firm

Assuming Pure MM View - Ideal Markets: Total Market Value of Assets of Firm (V) is

UNCHANGED. Value of un levered firm = Value of levered firm. Also, WACC remains

UNCHANGED by Capital Structure and Debt.

• WACCU = WACCL = 35%

Re = cost of equity

Rd = 18 % cost of debt

E = market value of the firm's equity

D = market value of the firm's debt =

V = E + D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

T = corporate tax rate

Re = ?

WACCu = 35%

rE,L =WACC + Debt/Equity (WACCL - rD,L)

Re = 35% + 2000/48000(35%-18%) 35.70%

WACC = E/V *Re + D/V * Rd * (1- T)

Now by plugging values

V= E+D = 48000+2000 = 50000

35% = (48000/50000) * Re + (2000/50000)* 18%

By rearranging equation

35% = 9.6 Re + .0072

.96Re = 35% - .0072

Re = (35%-.0072) / .96 = 35.70%

Cost of Equity for Levered Firm

= rE,L = Risk Free Interest Rate + Business Risk Premium + Financial Risk Premium.

Question No: 29 ( Marks: 3 )

Briefly explain what call provision is and in which case companies use this option.

Question No: 30 ( Marks: 3 )

Lakson Corporation is a stagnant market and analysts foresee a long period of zero growth of the firm. It is paying a yearly dividend of Rs.5 for some time which is expected to continue indefinitely. The yield on the stock of similar firm is 8%. What should lakson’s stock sell for?

Data:

P0 = ?

D1V1 = 5

RCE = 8%

Solution:

P0 = D1V1/RCE

P0 = 5/8%

P0 = 5/0.08

P0 = 62.5

Question No: 31 ( Marks: 5 )

What are different types of bonds? (Give any five types)

Types of Bonds:

Mortgage Bonds: backed & secured by real assets
Subordinated Debt and General Credit: lower rank and claim than Mortgage Bonds.
Debentures: These are not secured by real property, risky
Floating Rate Bond: It is defined as a type of bond bearing a yield that may rise and fall within a specified range according to fluctuations in the market. The bond has been used in the housing bond market
Eurobonds: it issued from a foreign country
Zero Bonds & Low Coupon Bonds: no regular interest payments (+ for lender), not callable (+ for investor)

Question No: 32 ( Marks: 5 )

H Corporation’s stock currently sells for Rs.20 a share. The stock just paid a dividend of Rs.2 a share (Do = Rs.2). the dividend is expected to grow at a constant rate of 11% a year.

 What stock price is expected 1 year from now?

 What would be the required rate of return on company’s stock?

Data:

P0 = rs 20

D0 = 2.

g = 11%

P1 = ?

ROR = ?

Solution Part A:

P1 = P0(1 + g)

P1= 20(1.11)

P1= 22.2

Solution part B:

ROR = D1 / P0 + g

ROR = (2 * 1.11/20) + 0.11

ROR = (2.22/20) + 0.11

ROR = 0.111 + 0.11

ROR = 0.221*100

ROR = 22.1%

Question No: 29 ( Marks: 3 )

Define interest rate risk and investment risk.

Interest rate risk

Interest rate risk is the risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration.

Investment Risk

The uncertainties attached while making an investment that the investment may not yield the expected returns.

Possibility of a reduction in value of an insurance instrument resulting from a decrease in the value of the assets incorporated in the investment portfolio underlying the insurance instrument. This reduction can also be effected by a change in the interest rate.

Question No: 30 ( Marks: 3 )

A stock is expected to pay a dividend of Rs.0.75 at the end of the year. The required rate of return is ks = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock's current price?

Data:

P0 =?

D1 = 0.75

g = 6.4%

ROR = 10.5%

Solution:-

P0 = D1 / (ror – g)

P0 = 0.75 / (0.105- 0.064)

Po = 0.75/0.041

P0 = 18.29

Question No: 31 ( Marks: 5 )

There are some risks (Unique Risk) that we can diversify but some of the risks (Market risks) are not diversifiable. Explain both types of risk.

Unique Risk

Allocation of proportional risk to all parties to a contract, usually through a risk premium. Also called risk allocation.

In finance and economics, systematic risk (sometimes called aggregate risk, market risk, or undiversifiable risk) is vulnerability to events which affect aggregate outcomes such as broad market returns, total economy-wide resource holdings, or aggregate income. In many contexts, events like earthquakes and major weather catastrophes pose aggregate risks—they affect not only the distribution but also the total amount of resources. If every possible outcome of a stochastic economic process is characterized by the same aggregate result (but potentially different distributional outcomes), then the process has no aggregate risk.

Question No: 32 ( Marks: 5 )

Hammad Inc. is considering two alternative, mutually exclusive projects. Both projects require an initial investment of Rs. 10,000 and are typical, average-risk projects for the firm. Project A has an expected life of 2 years with after-tax cash inflow of Rs. 6,000 and Rs. 8,000 at the end of year 1 and 2, respectively. Project B has an expected life of 4 years with after-tax cash inflow of Rs. 4,000 at the end of each of next 4 years. The firm’s cost of capital is 10 percent.

If the projects cannot be repeated, which project will be selected, and what is the net present value?

Net Present Value:

Project A: Initial investment, I0 = Rs 10,000

Cash flow in yr 1, CF1 = Rs 6000

Cash flow in yr 2, CF2 = Rs 8000

Discount rate, I = 10 %

No. of yrs, n = 4

NPV = - I0 + CF1/(1+i)n + CF2/(1+i)n + CF3/(1+i) n + CF4/(1+i) n

= -10,000 + 6000/(1.10) + 8000/(1.12)2

= -10,000 + 5454.54 + 6611.57

= - 10,000 +12066.11

= 2066.11

Project B: Initial investment, I0 = Rs 10,000

Cash flow in yr 1, CF1 = Rs 4000

Cash flow in yr 2, CF2 = Rs 4000

Cash flow in yr 3, CF3 = Rs 4000

Cash flow in yr 4, CF4 = Rs 4000

Discount rate, I = 10 %

No. of yrs, n = 4

NPV = - I0 + CF1/(1+i)n + CF2/(1+i)n + CF3/(1+i) n + CF4/(1+i) n

= -10,000 + 4000/(1.10) + 4000/(1.10)2+ 4000/(1.10)3+ 4000/(1.10)4

= -10,000 + 3636.36 + 3305.8 + 3005.25 + 2732.053

= -10,000 + 12679.463

= 2679.463

Question No: 30 ( Marks: 3 )

There are two stocks in the portfolio of Mr. N, Stock A and Stock B. the information of this portfolio is as follows:

Common stock Expected rate of return Standard deviation

Stock A 15% 10%

Stock B 20% 15%

Calculate the expected rate of return on this portfolio assuming that Stock A consists of 75% of the total funds invested in the stocks and the remainder in Stock B.

Solution:

Formula on page 93 of handouts.

(XA2 σ A 2 +XB2 σ B 2 + 2 (XA XB σ A σ B AB) x (0.5)

={(75/100)2(10/100)2+(25/100)2(15/100)2+2((75/100)(25/100)(10/100)(15/100)(.6)}(.5)

= {(0.5625)(0.01)+(.0625)(0.0225)+2((.75)(.25)(.1)(.15)(.6))}(.5)

=(0.010406)*.5

=0.005203*100

=0.520313%

Question No: 31 ( Marks: 5 )

(a) What is correlation of coefficient?

Correlation Coefficient ( AB or “Ro”):

Risk of a Portfolio of only 2 Stocks A & B depends on the Correlation between those 2 stocks.

The value of Ro is between -1.0 and +1.0

If Ro = 0 then Investments are Uncorrelated & Risk Formula simplifies to Weighted Average Formula. If Ro = + 1.0 then Investments are Perfectly Positively Correlated and this means that

Diversification does not reduce Risk.

If Ro = - 1.0, it means that Investments are Perfectly Negatively Correlated and the Returns (or Prices or Values) of the 2 Investments move in Exactly Opposite directions.

In this Ideal Case, All Risk can be diversified away. For example, if the price of one stock increases by 50% then the price of another stock goes down by 50%.

In Reality, Overall Ro for most Stock Markets is about Ro = + 0.6.it is very rough rule of thumb. It means that correlations are not completely perfect and you should remember that if the correlation coefficient is +1.0 then it is not possible to reduce the diversifiable risk.

This means that increasing the number of Investments in the Portfolio can reduce some amount of risk but not all risk

(b) What are efficient portfolios?

Efficient Portfolios are those whose Risk & Return values match the ones computed using Theoretical Probability Formulas. The Incremental Risk Contribution of a New Stock to a Fully

Diversified Portfolio of 40 Un-Correlated Stocks will be the Market Risk Component of the New Stock only. The Diversifiable Risk of the New Stock would be entirely offset by random movements in the other 40 stocks. Adding a New Stock to the existing Portfolio will create more Efficient Portfolio Curves. The New Stock will contribute its own Incremental Risk and Return to the Portfolio.

Question No: 32 ( Marks: 5 )

Maturity = 3 years

Coupon Rate = 15% p.a, Security = Machinery

You are required to calculate the cash flow of the bank which you will pay every month as well as the present value of this option.

Data:

Par Value = Rs 1, 000,000

Maturity = 3 years

Coupon Rate = 15% p.a,

Security = Machinery

Solution:

CF = Cash Flow = Coupon Value = Coupon Rate x Par Value

CF = 15% x 1,000,000

CF = 150000/12

Monthly CF = 12500

Assume that rD = 10%

PV = CF1/(1+rD/12)12+CFn/(1+rD/12)2x12 +..+CFn/ (1+rD/12) n +PAR/ (1+rD) n