EXAM FINAL SPRING 2006
SCHOOL OF BUSINESS BUSINESS FINANCE
NAME________________________________
Multiple Choice: Circle the one letter that represents the best answer. 15 questions, 2 pts/q, ~35 minutes. b 1. The hypothesis that market prices reflect all publicly-available information is called efficiency in the: a. Open form. a 2. a. b. c. d. e. b. Semi-strong form. c. Strong form. d. Weak form. e. Nice form.
Which of the following assets likely has the SECOND highest level of risk? Common stock of the largest companies in the United States. US Treasury bills. Common stock of the smallest companies listed on NYSE. Long-term government bonds. Long-term corporate bonds.
d
3. You note that the returns of investment A tends to vary only slightly from its average return, definitely less so than does investment B's returns. Based on this, you believe that: a. A has a lower inflation premium than B. b. A has a higher standard deviation than B. c. A has a higher correlation than B. d. A has a lower return variance than B. e. A must be one of the smallest firms listed on the NYSE, while B must be one of the 500 largest stocks in the United States. f. None of these are worth believing. 4. Which of the following is false regarding risk and return? a. The risk-free asset earns the lowest rate of return. b. Based on historical data, there are ample rewards for bearing risk. c. The reward for bearing risk is driven by an asset's standard deviation. d. An increase in the risk of an investment will result in an increased risk premium. e. In general, the higher the risk the higher the expected return. f. The above statements are all true. 5. The linear relation between an asset's expected return and its beta coefficient is the: a. Security market line. b. Portfolio weight. c. Portfolio risk. d. Risk to reward ratio. e. Market risk premium. f. Gravy premium. 6. The CAPM implies that the expected return for a particular asset does NOT depend on: a. The reward to risk ratio. b. The reward for bearing systematic risk. c. The pure time value of money. d. The amount of unsystematic risk. e. The risk-free interest rate. f. Under the assumptions of the CAPM, the expected return depends on all of these.
c
a
d
version a
1
FINAL EXAM
BUSINESS FINANCE
d
7. Stock A has a beta coefficient of 0.9, and stock B has a beta coefficient of 1.2. Which of the following statements is false regarding these two stocks? a. Stock A is less risky from the market's perspective than a typical stock, and stock B is more risky than a typical stock. b. Stock B, if purchased, will increase the market risk of a portfolio more than stock A would (if purchased). c. Stock B must have a higher expected return than stock A if markets are efficient. d. Stock A necessarily must have a lower standard deviation of returns than stock B. e. Stock A has the same reward to risk ratio as stock B. f. The above statements are all true.
d
8. Your firm invests in a set of risky projects that increase the diversifiable risk of the firm without changing its systematic risk. All else the same, the expected risk premium on your firm's stock is most likely to: a. Increase, because the difference between the expected return on the firm's stock and the riskfree rate will widen. b. Decrease, because the difference between the expected return on the firm's stock and the riskfree rate will narrow. c. Increase or decrease, depending on the internal rate of return of the new projects. d. Remain unchanged, because the level of systematic risk is unchanged. e. Increase or decrease, but more information is needed.
b
9. Given the following information: The risk-free rate is 7%, the beta of stock A is 1.2, the beta of stock B is 0.8, the expected return on stock A is 13.5%, and the expected return on stock B is 11.0%. Further, we know that stock A is fairly priced and that the betas of stocks A and B are correct. Which of the following must be true? a. Stock B is also fairly priced. b. The price of stock B is too high. c. The price of stock A is too high. d. The expected return on stock B is too high. e. The expected return on stock A is too high. f. Given the information above, none of these are true.
b
10. The equivalent annual cost can be defined as: a. The yearly costs, which are standard in two mutually exclusive projects that have equal lives. b. The amount paid each year over the life of a project that has the same net present value as the project. c. The amount of the yearly fixed costs of a project, which remains constant over the life of the project. d. The net present value of a project divided by the number of years that the project is expected to last. e. The net present value of the yearly fixed costs of a project that is constant over the life of the project. f. None of these are accurate definitions.
version a
2
FINAL EXAM
BUSINESS FINANCE
d
11. What is the expected return on a portfolio that is invested 30% in stock A and 70% in stock B, given the following information? Economic State Probability of State Return on Stock A Return on Stock B Normal 80% 8% 7% Boom 20% 15% 6% a. 5.88% b. 7.16% c. 7.43% d. 7.58% e. 7.90% f. None of these.
e
12. The equity risk derived from the firm's capital structure policy is called a. market b. systematic c. extrinsic d. business e. financial
risk. f. synthetic
e
13. The Best Company is reviewing two options for replacing a piece of machinery. The first machine costs $86,500 and has a four-year life. The second machine costs $123,000 and has a sixyear life. Neither machine will have a salvage value. The machines will be replaced at the end of their life. What method below would be best suited to determine which machine to purchase? a. Net present value b. Internal rate of return c. Accounting rate of return d. Total cash flows e. Equivalent annual cost f. None of these methods are useful
f
14. Phat Pow Development Co. purchased a tract of land two years ago for $1.2 million. Within a year, the company spent $175,000 to have the land graded so that it is usable. Just last month the company spent $50,000 in legal fees to have the land rezoned for commercial use. The company is now trying to decide if they want to build one large retail store on the property or a strip mall consisting of smaller stores. Which of the specific costs identified above should be included in the project analysis to determine the best use of the property? a. All of the identified costs b. Only the $1.2M cost of the land and the grading c. Only the legal fees and the grading costs d. Only the $1.2M cost of the land and the legal fees e. Only the legal fees f. None of the identified costs
a
15. A firm that uses its WACC to evaluate projects without regarding the risk class of the project will: a. Tend to become riskier over time. b. Tend to only accept low-risk projects. c. Tend to outperform its peers. d. Tend to become less risky over time. e. Tend to ignore managerial options. f. None of these are likely.
version a
3
FINAL EXAM
BUSINESS FINANCE
Short Answer and Problem Solving: Give concise answers and show your work, respectively. Note: In responding to "WHY/Explain" you should give a meaningful explanation that would convince a skeptic. 8 questions, [points in brackets], ~75 minutes. Use the following tables to answer questions 1 through 5: Company KAT AMZN BTP Business Fashion Design Web Retailing Conglomerate 2001 +50% Equity Beta 2.20 2.84 Standard 30% Deviation 50% Debt 50% 10% 30% Equity 50% 90% 70% Stock Price $24 $25 $40 2004 -8% Dividend per year $0.25 $0.00 $1.00 E(rA)
BTP's Returns
2002 +40%
2003 -10%
Risk-free rate: 3% Expected return on the market: 13% Corporate tax rate = 35% All debt betas ( D) = 0 1. Calculate the expected return and standard deviation of stock "BTP". (5) E[R]=(.50+.40-.10-.08)/4=.18
2
.50 .18 0.3145
2
.40 .18
2
.10 .18 4 1
2
.08 .18
2
0.2968 .0989 3
2. Assume that the expected return you calculated in #4 for BTP's stock is correct. What should BTP's equity beta be? (5) Using the CAPM: .18=.03+BBTP(.13-.03) BBTP = 1.5 3. What should BTP's WACC be? (5) The quickest way to do this is to unlever BTP's equity beta and then use the CAPM:
E
A, BTP E , BTP D , BTP
D
E D E D 70 1.5 0 1.05 A, BTP 70 30 E[ RA, BTP ] .03 1.05(.13 .03) .135
Alternatively, you could calculate BTP's WACC:
version a
4
FINAL EXAM
BUSINESS FINANCE
E
A, BTP E , BTP D , BTP
D
E D E D E[ RE , BTP ] .03 1.5(.13 .03) .18 18% E[ RA, BTP ] 70 30 .18 .03(1 .35) .13185 70 30 70 30
The difference is due to using WACC adjusted for taxes. Either approach is defensible.
4. BTP is a conglomerate. Its two divisions are fashion and coffee retailing. What is the appropriate discount rate for NPV decisions in its fashion division? (8) You would need to come up with the appropriate discount rate for investment in the fashion business. This should be given by KAT, which is a fashion company. We can observe that KAT's equity beta is 2.2. However, we need its asset beta. We must unlever KAT's equity beta and then use the asset beta to get an expected return on assets employed in the fashion business. That is the appropriate discount rate for the fashion division.
50 0 1.1 50 50 E[ Ra ] .03 1.1(.13 .03)
a
2.2
0.14
5. Assume that BTP's fashion business is much riskier than its coffee retailing business. Also assume that BTP has a policy of using its WACC to evaluate projects in either division. Explain exactly what is wrong with this policy and what kind of errors it would cause in each division. (7) The mistake would come from using the company's average discount rate rather than project specific rates. On average, you would be using too low of a discount rate in the high-risk division and too high of a discount rate in the retail division. This would lead to accepting some truly negative NPV projects in the high-risk division and rejecting some truly positive projects in the retail division.
6. Bill Miller, who runs Legg Mason's Value Trust Fund, beat the S&P500 15 years in a row. Does this mean that the US stock market is not efficient? (7) Just because one person or a couple of people consistently beat the market does not mean that the market is inefficient. Anytime thousands of people do something, just by pure chance, some will be incredible lucky. This is the idea behind order statistics. Thus, even though there is a very small probability that any particular person will beat the market 15 years in a row, the probability that someone will do so, just by chance, is actually quite high.
version a
5
FINAL EXAM
BUSINESS FINANCE
7. You have two stocks in your portfolio: Amazon.com and Merck (a drug company). Amazon.com has an expected return of 60% and Merck has an expected return of 40%. The standard deviation of Amazon.com's return is 90% and the standard deviation of Merck's return is 30%.The correlation between the two stocks is 0.2. You have 80% of your money in Amazon.com and 20% of your money in Merck. a. What are the expected return and standard deviation for your portfolio? (4)
b. You sell your Merck stock and replace it with Microsoft. If Microsoft's standard deviation of returns is also 30%, do you expect your portfolio variance to change? Explain your reasoning. (6) I would expect my portfolio variance to change. Microsoft is a high technology company and is likely to have a higher correlation with Amazon.com because they are in similar industries and are both affected by many of the same events. Thus, the correlation coefficient between Amazon.com and Microsoft should be higher than the correlation coefficient between Amazon.com and Merck. This will result in a higher portfolio variance because there will be less offsetting moves in the two stocks (they will tend to move together, creating wider swings in portfolio value).
version a
6
FINAL EXAM
BUSINESS FINANCE
8. Hagen-Dazs wants to capitalize on the latest diet craze: the low-carbohydrate Synthesol diet. They are considering a new product line of "zero-carb" ice creams to sell in grocery stores. This new product line will only exist for 3 years, as Hagen-Dazs is certain that the low-carb diet fad will fade after 3 years. They will need to use both existing equipment and invest in new equipment worth $200,000. The new equipment will be depreciated under the straight-line method over 5 years. They will be able to sell this new equipment for $40,000 at the end of three years; it will otherwise be worthless to them. The existing equipment is currently fully-depreciated, and currently has no other use at the company. Hagen-Dazs could sell this equipment for $10,000 today; it will be worthless after 3 years. The company projects increases in revenue of $260,000 each year for 3 years, with additional costs of $170,000 each year. Net working capital will increase by $30,000 today if the project is taken, and return to its pre-project level at the end of year 3. The tax rate is 34%. Should Hagen-Dazs embark on this venture? Their cost of capital is 11%. (18 pts)
I solved this using the following setup, with the following calculations: Proceeds in year 3 = 40000 (40000 80000)*(0.34) = 53600 ** because we sold at a loss, we get a tax shield for this, and thus our cash flow is greater than our selling price. Opportunity cost = 10000 (10000 0)*(0.34) = 6600
0 revenues - costs - depr = EBIT - taxes (34%) = NI + depr - cap exp + proceeds - opp cost - NWC = FCF 1 260.0 170.0 40.0 50.0 17.0 33.0 40.0 2 260.0 170.0 40.0 50.0 17.0 33.0 40.0 3 260.0 170.0 40.0 50.0 17.0 33.0 40.0 53.6 6.6 30.0 -236.6 73.0 73.0 -30.0 156.6
200.0
Calculating the NPV:
NPV
236.6
73 73 1.11 1.112
156.6 1.113
7.75
The NPV is positive, so Hagen-Dazs should undertake the project.
version a
7
FINAL EXAM
BUSINESS FINANCE
9. Why do we use beta in the CAPM instead of standard deviation? (5) The CAPM determines the amount of return given a unit of systematic risk. Standard deviation measures total risk (sys. + unsys.), while beta measures systematic risk. Because unsystematic risk can be diversified away, the market only rewards investors for bearing systematic risk. That is why we use beta instead of standard deviation.
Extra credit [3 points]:
10. You need a new machine for an upcoming product launch. You plan to keep producing for the foreseeable future. Two vendors have submitted bids (in thousands of dollars). One offers a machine that costs $50, and would require maintenance expenditures of $10 per year. The machine would last for 3 years. The other machine would cost $40, have maintenance expenditures of $8, but would only last for 2 years. Your discount rate is 10%. Which machine should you buy? Show your work. This is an EAC question.
50 10 40
1 1 .10 .10 1.10 3
74.87, meaning an EAC of 30.106
8 8 1.10 1.102
53.88, meaning an EAC of 31.045
So you should pick the first machine.
version a
8