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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 11

1

g

r g r

= $25,322.71

41 1 .04

1.07 .04 1 .07

= $97,110.01

Question 5 Consider the following investment alternatives, where APR stands for Annual Percentage Rate. Which alternative offers the highest Annual Effective Rate?

Investment APR Compounding A 6.25% Annual B 6.10% Daily C 6.125 Quarterly D 6.120 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 1 2 

Revenues 1200 1400 

Operating Expense 450 525

Depreciation 240 280 

Increase in working capital 60 70 

Capital expenditures 300 350 

Marginal corporate tax rate 30% 30% 

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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 Coupon rate Yield-to-Maturity Time-to-Maturity Market price A 2% 2% 1 year $1,000 B 5% 4% 18 years $1,000 C 6% 6% 23 years $1,000

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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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) the bond's yield to maturity is less than its coupon rate. B) the bond's yield to maturity is equal to its coupon rate. C) the bond's yield to maturity is greater than its coupon rate. D) 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 1 2 3 4 5 

FCF (€ millions) 25 28 32 37 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

Lowes 

Realized 

Return

Home Depot 

Realized 

Return

IBM 

 Realized 

Return 

2000 20.1% -14.6% 0.2% 

2001 72.7% 4.3% -3.2% 

2002 -25.7% -58.1% -27.0% 

2003 56.9% 71.1% 27.9% 

2004 6.7% 17.3% -5.1% 

2005 17.9% 0.9% -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 

Realized 

Home Depot 

Realized 

Lowes 

Deviation 

Home Depot 

Deviation 

(RL - RL)  

× 

10

Return Return (RL - RL) (RH - RH) (RH - RH) 

2000 20.1% -14.6% -4.7% -18.1% 0.00843889 

2001 72.7% 4.3% 47.9% 0.8% 0.00391456 

2002 -25.7% -58.1% -50.5% -61.6% 0.31079056 

2003 56.9% 71.1% 32.1% 67.6% 0.21727489 

2004 6.7% 17.3% -18.1% 13.8% -0.02496211 

2005 17.9% 0.9% -6.9% -2.6% 0.00177389 

average = 24.8% 3.5%

Variance = 0.125447467 0.1777954

          SD = 0.354185639 0.4216579

Covariance = 0.103446 

Correlation = 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

Average 

Monthly 

Return (%) IBM Factor 

Betas

Rm - rf 0.64 0.712

SMB 0.17 -0.103

HML 0.53 0.124

PR1 YR 0.76 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

Average 

Monthly 

Return (%)

IBM 

Factor 

Betas

IBM 

Return 

Calc.

Rm - rf 0.64 0.712 0.456

SMB 0.17 -0.103 -0.018

HML 0.53 0.124 0.066

PR1 YR 0.76 0.276 0.210

E[Rs] = 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 A B T-Bill Market portfolio expected return 14.5% 19.75% 4.0% 18.0%

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standard-deviation 15.0% 20.0% 0 16.0% correlation with the market portfolio 0.8 0.9 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:

mpPm

fmfP

rrErrE

)()(

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 State of the weather Return Cinema Corp. Return Beach Inc. 0.2 rainy 30% 5% 0.5 cloudy 20% 15% 0.3 sunny 10% 40%

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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 cum-coupon 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.