Finance 351 2012 Semester 1 Test Questions

FINANCE351

ACCOUNTING AND FINANCE

TERMS TEST 2012

Finance 351 FC - ADVANCED FINANCIAL MANAGEMENT

(Time allowed: 1 hour and 20 minutes)

Instructions to Students:

WRITE your FULL NAME (surname first) and STUDENT ID number in the space provided at the top of each page of this booklet.

This examination paper comprises SEVEN questions. ALL questions are COMPULSORY and should be answered.

Marks may be DEDUCTED if you fail to show complete workings.

WRITE NEATLY in the space provided – illegible answers will NOT be marked.

ADDITIONAL WRITING SPACE is provided at the end of the paper. You must record the number of the question.

If any question is not clear please state all assumptions you make.

FORMULAE are provided in the APPENDIX.

Surname:_______________________________________________________

First Name:______________________________________________________

Student ID:_____________________________________________________

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Surname:________________________ 2 FINANCE351First Name:______________________

Question Max. Mark

Mark

1 8

2 8

3 3

4 8

5 5

6 12

7 6

Total 50

THE REST OF THIS PAGE IS BLANK

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Surname:__________________________ 3 FINANCE351First Name:________________________

Question 1

(a) List and briefly discuss two selfish strategies that shareholders and/or managers may use to expropriate debtholders’ wealth, which may deviate from a firm’s optimal investment policy. Also briefly describe what kind of deviation is associated with each selfish strategy.

Write neatly in no more than the space provided. (4 marks)

Selfish Strategy One

Selfish Strategy Two

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Question 1 – continued

(b) Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which is currently occupied by an abandoned warehouse. Last month, its marketing department spent $10,000 on market research to determine the number of potential of customers for the new store. Home Builder Supply can thus decide whether to build and open the new store now.

Which of the following should be included as part of the incremental earnings for the proposed new retail store?

i. The costs of demolishing the abandoned warehouse and clearing the lot.

ii. The loss of sales in the existing retail outlet, if customers who previously drove across town

to shop at the existing outlet become customers of the new store instead.

iii. The cost of $10,000 spent in market research to evaluate the potential number of customers.

iv. The current market value of the land if sold.

Briefly discuss your answers. Write neatly in no more than the space provided. (4 marks)i. The cost s of demolishing the abandoned warehouse and clearing the lot

ii. The loss of sales in the existing retail outlet

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Question 1(b) – continued

iii. The cost spent in market research to evaluate the potential number of customer s

iv. The current market value of the land if sold

(Total for Question: 8 marks)

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Question 2Neon Corporation's stock returns have a covariance with the market portfolio of 0.048. The standard deviation of the returns on the market portfolio is 20 percent, and the expected market risk premium is 7.5 percent per annum. The company also has 5 million shares of common stock outstanding, each sold for ¥20. The company's CEO considers that the firm's current debt-equity ratio is optimal. The corporate tax rate is 30 percent, and the yield of government bonds is currently 5.6 percent per annum.

Neon Corporation has bonds outstanding with a total market value of ¥25 million and a coupon rate of 7 percent. Neon’s bonds, which have credit rating of BBB, are not traded in the secondary market. On average, corporate bonds rated with BBB have 240 basis points (bps) spread over government bonds.

Calculate Neon’s cost of equity and its weighted average cost of capital (WACC) using the framework of the capital asset pricing model (CAPM).

(8 marks)Neon Corporation's cost of equity

Question 2-continued

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N eon Corporation's weighted average cost of capital


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Question 3A firm has an asset used in a four-year project, which falls in the five-year Modified Accelerated Cost Recovery System (MACRS) class for tax purposes. The firm incurred $1 million to acquire the asset and will sell it for $180,000 at the end of the project. If the tax rate is 30 percent, what is the after-tax salvage value of the asset?

Depreciation (in percent) under Modified Accelerated Cost Recovery System (MACRS)Recovery Period – 5 Years

Year 1 2 3 4 5 6Depreciation .200 .320 .192 .115 .115 .058

(3 marks)

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Question 4You are required to compare two stocks listed on the New Zealand Stock Exchange Main Board (NZSX): the Warehouse Group Limited (WHS) and Briscoe Group Limited (BGR). Both companies are department stores in the service sector of NZSX. You have collected financial data regarding their stock prices etc., as follows:

Company (1) Price(2) 52-week

Change(3) Market Cap (mil)

(4) Book Value/Shar

e

(5) D/E Ratio

(6) VC/FC(7) Average OCF (mil)

(8)Volatility in OCF (mil)

The Warehouse Group Limited

$2.74 -18.37% $847.96 $0.88 67.81% 2.16 $139 $38.738

Briscoe Group Limited

$1.55 10.87% $329.12 $0.60 0 1.88 $28 $13.140

(1) Price = Most recent stock price.(2) 52-week Change = The percentage change in price from 52 weeks ago.(3) Market Cap = Current Market Price per Share x Number of Shares Outstanding.(4) Book Value per Share = Total Common Equity / Total Common Shares Outstanding.(5) D/E Ratio = Total debt/ Total equity.(6) VC/FC = The ratio of variable costs to fixed costs.(7) Average OCF = Average annual operating cash flows in the past four years.(8) Volatility in OCF = The standard deviation of net operating cash flows in the past four years.

There are two parts to this question.

(a) Based on the “size effect” asserted by Banz (1981) and the “value effect” indicated by Fama and French (1998), which stock is expected to perform better in the long term (e.g. 5 years)? Briefly discuss your reasons using the data from the above table in no more than the space provided.

(5 marks)W hich company is expected to perform better in the long-run?

Size Effect

Question 1(a) – continued

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Value effect

(b) Supposed that based on your calculations, the four-year equity beta coefficients of WHS and BGR are 0.65 and 1.05, respectively. Which factor do you think is the most important one which leads to this difference? Point out the key factor using data from the Table to briefly discuss your reasons in no more than the space provided.

(3 marks)


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Question 5

Markov Manufacturing recently spent $2 million to purchase some equipment used in the manufacture of disk drives. The firm expects that this equipment will have a useful life of five years, and its marginal corporate tax rate is 20%. The company plans to use straight-line depreciation and its management decides the appropriate discount rate to be 10% per annum.

After the company starts producing its products using the new equipment, over the following 5 years, it will incur fixed costs of $1.5 million each year. Each disk drive sells for $150, and the variable cost per drive is $100. Assume that all operating cash inflows from product sales occur at the end of each year. Income tax credit will be refunded immediately in case the company incurs a loss in that year.


(a) If Markov Manufacturing wants this project to be financially break-even, how many units of disk drives should this company sell per year? Assume the same number of disk drives will be sold each year.

(3 marks)The financial break-even sales volume


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(b) Now suppose that the annual fixed cost is $1.6 million, instead of $1.5 million. How does this change affect the financial break-even sales volume? Explain your answer neatly in no more than the space provided. Detailed numerical calculations are not required.

(2 marks)

T he change in the financial B/E sales


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Question 6 (a)

There are three parts to this question.

(a) Old School Corporation has an expected EBIT (earnings before interest and taxes) of $1.5 million per year in perpetuity. The company currently has no debt, and its cost of equity is 15 percent per year. If the corporate tax rate is 25 percent, what is the value of the firm?

(2 marks)

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Question 6 - continued

(b) Old School Corporation has decided to repurchase part of its common stock by issuing perpetual corporate bonds worth of $6 million. The company’s cost of debt is 8 percent per year. Suppose the only capital market imperfection is corporate taxes.

After the repurchase announcement, what will be the debt-equity ratio of Old School Corporation? What will be its equity cost of capital? Calculate the firm’s equity cost of capital by using Modigliani and Miller’s Propositions with corporate taxes .

(8 marks)

The debt-equity ratio of Old School Corporation after restructuring

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Question 6(b)(b) - continued

Old School ’ s cost of equity according to M&M Propositions with corporate taxes

Question 6

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- continued

(c) According to Modigliani and Miller’s Propositions without taxes , what is the debt-equity ratio that will maximize the value of a firm? Briefly discuss your answers in no more than the space provided.

(2 marks)


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Question 7

Ang Electronics, Inc. is examining a 5-year project to develop a new DVDR with two stages of investment. The 1st stage the project, the research and development (R&D) stage, lasts for one year. The 2nd stage of the production and sales for the new DVDR lasts for 4 years. Ang Electronics, Inc. expects to incur $1.2 million for the initial R&D cost in the beginning of the project. The company will incur $1 million for producing the new product in one year after the company starts the R&D testing. The R&D results will be revealed within one year, i.e., before the company starts producing the new DVDR.

If the initial R&D is successful, this project can generate operating cash flows $900,000 per year for four consecutive years starting from the end of the 2nd year of the project. However, if the initial R&D fails, the company’s operating cash flows will fall to $500,000 per year. Suppose that there is a 60 percent chance of success and all operating cash inflows occur at the end of each year. The proper discount rate is 10 percent per annum.


(a) What is the traditional net present value (NPV) of this project when the company is expected to proceed with 2 stages of investment? Will you suggest this company conduct the R&D testing of the new DVDR? (3 marks)

NPV value and suggestion

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(b) What is the value of this project based on the decision tree analysis (DTA), where the company has the flexibility to change their strategies after the information regarding the result of R&D is revealed? Will you suggest this company conduct the R&D testing of the new DVDR?

(3 marks)DTA value and suggestion

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Question 7(b) – continued


END OF TEST QUESTIONS

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ADDITIONAL WRITING SPACERemember to write the number of the question you are answering

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Surname:________________________ 23 FINANCE351First Name:______________________

APPENDIX

(if the firm has debt) (if the firm has no debt)

Documents

Finance 351 2012 Semester 1 Test Questions