Suggested Answers to Sample Final Exam 1 1 FNCE10002 Principles of Finance Semester 2, 2021 Sample Final Exam 1 Questions 1 to 9 [9 × 4 = 36 marks] State whether the following statements are true or false and provide a brief explanation. Your answer must begin with True or False followed by your explanation. Note that your explanation cannot just be a restatement of the question statement. Q.1 Two sign reversals in a project’s cash flow stream is only a necessary condition for two internal rates of return to exist. Your answer must begin with True or False followed by your explanation. Q.2 If a firm accepts a zero net present value project then the value of the firm may increase or decrease depending on whether the project’s internal rate of return was relatively high or low, respectively. Your answer must begin with True or False followed by your explanation. Q.3 The payback period method of project evaluation discriminates against projects with long establishment periods and large cash flows later in their lives. Your answer must begin with True or False followed by your explanation. Q.4 Investors who purchase shares after the ex-dividend date are entitled to receive the dividend to be paid on the payment date. Your answer must begin with True or False followed by your explanation. Q.5 An investor wishes to hedge against the possibility of a significant fall in the price of QAF Ltd shares. If the investor currently owns these shares this risk can be hedged by selling call options on the shares. Your answer must begin with True or False followed by your explanation. Q.6 As the exercise price increases for an option, all else being the same, the value of a put option will decrease, and the value of a call option will increase. Your answer must begin with True or False followed by your explanation. Q.7 An investor who purchases a call option or sells a put option is expecting the price of the underlying shares to rise. Your answer must begin with True or False followed by your explanation. Q.8 The expected return of a zero beta security is zero. Your answer must begin with True or False followed by your explanation. Q.9 Short selling a risky security refers to the strategy of borrowing and selling that security when you expect the security’s price to rise in the future. Your answer must begin with True or False followed by your explanation. Suggested Answers to Sample Final Exam 1 2 Questions 10 and 11 consider the following information [10 + 4 = 14 marks] The annual report of WTC Ltd provides the following information about the firm. It has 20 million ordinary shares outstanding with a current market price of $1.50 per share. The beta of ordinary shares is 1.5, the market risk premium is 8% p.a. and the riskfree rate is 6% p.a. The firm’s debt consists of 100,000 bonds paying an annual coupon rate of 10% at the end of each year and maturing in 4 years’ time. Each bond has a face value of $100 and the current yield to maturity on these bonds is 8.0% p.a. The company tax rate is 30%. Q10. Calculate WTC’s after-tax weighted average cost of capital. Show all calculations. Q11. Outline the two circumstances in which the weighted average cost of capital cannot be used in analyzing the investment projects being considered by the firm. What is typically recommended that a firm do in such situations Questions 12 and 13 consi
der the following information [6 + 8 = 14 marks] HVH Ltd is considering two mutually exclusive projects where project A has a life of 5 years while project B has a life of 7 years. The cash flows related to the two projects are as follows: Year Project A Project B 0 –$300,000 –$300,000 1 $100,000 $80,000 2 $100,000 $80,000 3 $100,000 $80,000 4 $100,000 $80,000 5 $100,000 $80,000 6 – $80,000 7 – $80,000 The discount rate appropriate for evaluating these projects is 10% p.a. 12. Calculate the NPV of each project. 13. Which project should the firm accept and why Clearly state any assumption(s) required for your analysis. Question 14 [10 marks] KLC Ltd is evaluating an investment project with the following information: Project life 2 years Initial project cost $400,000 Real before-tax net operating cash flows $350,000 per annum Real after-tax salvage value in year 2 $14,000 Corporate tax rate 30 percent Nominal project discount rate 10.24% per annum Expected inflation rate 4.00% per annum Assuming end-of-year cash flows, calculate the NPV of this project. What decision should the firm make Show all calculations. Suggested Answers to Sample Final Exam 1 3 Questions 15 and 16 consider the following information [7 + 2 = 9 marks] You are given the following information on two stocks and the market portfolio. Note that the diagonal terms are variances of returns and the off-diagonal terms are covariances of returns. Variances and Covariances Security/Portfolio Delta Ltd Omega Ltd Market Portfolio Delta Ltd 0.250 Omega Ltd 0.060 0.090 Market Portfolio 0.030 0.050 0.040 15. You have $50,000 available to invest and you form a portfolio by short selling $30,000 worth of Delta Ltd and investing all the available funds in Omega Ltd. Calculate the beta of this portfolio. Show all calculations. 16. If the market portfolio’s return unexpectedly falls by 2 percent what, if anything, will happen to the portfolio’s return Explain. Questions 17 to 20 consider the following information [6 + 6 + 3 + 2 = 17 marks] The CFO of the CSC Ltd is considering a recapitalization plan that would convert CSC from its current all-equity capital structure to one including substantial financial leverage. At present, CSC has 250,000 ordinary shares outstanding, which are selling for $60.00 each, and the recapitalization proposal is to issue $7,500,000 worth of long-term debt at an interest rate of 6.0 per cent and use the proceeds to repurchase 125,000 ordinary shares worth $7,500,000. CSC’s expected EBIT next year will be $2,000,000. Assume there are no market frictions such as corporate or personal income taxes. 17. Calculate the number of shares outstanding, the share price and the debt-to-equity ratio for CSC if the proposed recapitalization is adopted. Show all calculations. 18. Calculate the expected earnings per share and return on equity for CSC’s shareholders under the expected EBIT for both the current all-equity capitalization and the proposed mixed debt/equity capital structure. Show all calculations. 19. Calculate the breakeven level of EBIT where earnings per share for CSC’s shareholders are the same under the current and proposed capital structures. Show all calculations. 20. At what level of EBIT will CSC’s shareholders earn zero EPS under the current and the proposed capital structures Show all calculations.