Finc 340 Final - Final Exam Finance 340 Autumn 2007 Name...

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Unformatted text preview: Final Exam Finance 340 Autumn 2007 Name: Exam Instructions: This exam has 9 pages (including this one), plus a blank, last page. Multiple-choice questions total 10, and are worth 2 points each. There are 8 shortanswer and problem-solving questions, some with multiple parts. The point value is given for each of these problems. The entire exam is worth 100 points. Please write your name at the top of each page of the exam. You may use a calculator and the provided formula sheet on this exam. You must show your work in order to receive credit for your answers. Partial credit will be given for partially correct answers. If a question asks "Why/Explain", you should give an explanation that would convince a skeptic. You may use extra space on the last page (page 10), or the formula sheet (be certain to hand it in), if you need additional space to write an answer. Suggestions: Use your time wisely. Move on to another problem if you feel like you're stuck. You may ask me questions if you are unclear about a problem. I might be able to clarify the problem for you. GOOD LUCK!! Happy Holidays! version b 1 FINAL EXAM AUTUMN 2007 BUSINESS FINANCE Multiple Choice: Circle the ONE letter that represents the best answer. 10 questions, ~20 minutes. e 1. a. b. c. d. e. e 2. I. II. III. IV. a. a 3. I. II. III. IV. The principle of diversification tells us that: concentrating an investment in two or three large stocks will eliminate all of your risk. concentrating an investment in three companies all within the same industry will greatly reduce your overall risk. spreading an investment across five different companies will not lower your overall risk at all. spreading an investment across many different assets will eliminate all of the risk. spreading an investment across many different assets will eliminate some of the risk. Which of the following are examples of systematic risk? An increase in the productivity of Black Diamond Co. workers The U.S. launches an attack on Iran Bernanke (at the Federal Reserve) continues to decrease interest rates Olympia brewing spills 80,000 gallons of beer into the streets of Tumwater I & II only b. I & III only c. II & IV only d. I & IV only e. II & III only Which of the following statements are correct concerning diversifiable risks? Diversifiable risks can be reduced by investing in a portfolio of several unrelated securities. The market rewards investors for diversifiable risk by paying a risk premium. Diversifiable risks are generally associated with an individual firm or industry. Beta measures diversifiable risk. b. II & IV only c. I & IV only d. II & III only e. I, II, & III only a. I & III only a 4. a. b. c. d. e. c 5. a. b. c. d. e. 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. Long-term corporate bonds. Long-term government bonds. Common stock of the smallest companies listed on NYSE. The overall cost of capital for a retail clothing store: is equivalent to the after-tax cost of the firm's liabilities. should be used as the required return when analyzing a potential acquisition of a wholesale distributor. reflects the return investors require on the total assets of the firm. should be evaluated using the WACC of a company that sells sports clothing and equipment. is unaffected by changes in corporate tax rates. version b 2 FINAL EXAM AUTUMN 2007 BUSINESS FINANCE version b 3 FINAL EXAM AUTUMN 2007 BUSINESS FINANCE f 6. Risk that affects at most a small number of assets is called _____ risk. b. market c. non-diversifiable d. systematic e. tweaked f. none of these a. portfolio e 7. When firms develop a WACC for individual projects based on the cost of capital for other firms in similar lines of business as the project, the firm is utilizing a _______ approach. b.subjective risk c. divisional cost of capital d. capital adjustment e. pure play a. SML e 8. Which of the following statements are correct concerning the security market line (SML) approach to estimate the cost of equity? I. The SML approach considers the amount of systematic risk associated with an individual firm. II. The SML approach can be applied to more firms than the dividend growth model can. III. The SML approach generally relies on the past to predict the future. IV. The SML approach generally assumes that the reward-to-risk ratio is constant. a. I & III only b. II & IV only c. III & IV only d. I, II, & III only e. I, II, III, & IV d 9. You discover the engine-oil additive your scientists developed three years ago makes a great men's after-shave once diluted properly using certain chemicals. How should you treat the original $125,000 of R&D expenditures that went into developing the engine-oil additive for your present decision regarding whether or not to begin production of the after-shave? a. Treat it as a cash outflow three years ago for the current project; that is, find the future value today of the $125,000 spent three years ago. b. The full $125,000 should be treated as an initial investment today. c. As a cash inflow since the formula has obviously increased in value over the years. d. As a sunk cost since the R&D expenditure has no bearing on today's decision. e. As an opportunity cost if the formula cannot presently be sold to another manufacturer. 10. Sanford & Sons has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 65 percent of the firm's overall sales. Division A is also the riskier of the two divisions. Division B is the smaller and least risky of the two. When the company is deciding which of the various divisional projects should be accepted they should: a. b. c. d. e. f. allocate more funds to Division A since it is the largest of the two divisions. fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values. allocate the company funds to the projects with the highest net present values based on the firm's weighted average cost of capital. assign different discount rates to each project and then select the projects with the highest net present values. fund the highest net present value projects from each division based on an allocation of 65 percent of the funds to Division A and 35 percent of the funds to Division B. do none of the above, as none of these are the correct way to proceed. d version b 4 FINAL EXAM AUTUMN 2007 BUSINESS FINANCE Short Answer & Problem Solving Approximately 1 hour 40 minutes. 1. You are examining Costco's stock. Its beta is 0.9, the expected return on the market is 11.5% and the risk free rate is 3.5%. Assume that Costco is currently priced to yield an expected return of 12%. Is it under-priced or over-priced? For credit, you must briefly explain why this is the case. [5 pts] If you go through and do the CAPM for this stock, you see that it should be priced to earn a 10.7% expected return. Since it is priced to earn more than that, it is priced too low (its price is attractive to new purchasers of the stock, who will bid up the price, and decrease the expected return down to the SML). Thus, it is underpriced. 2. You are in charge of purchasing new computer servers for your company. One option, the FinanceRules5000 costs more, but lasts longer and has lower maintenance costs (because of its high quality). The other, the StatsBites1000, costs less, has higher maintenance costs and a shorter life. The cash flows for each are given below. You plan to commit to a long-term, repeating contract for whichever server you pick. If your discount rate is 10%, which one is the best choice? [5] 0 1 2 3 4 FR5000 -100 -5 -5 -5 -5 SB1000 -50 -20 -20 -20 Use the EAA/EAC tool: 1 1 NPV FR = -100 - 5 - = -115.85 .10 .10(1.10 ) 4 EAC FR = - 115.85 1 1 - .10 .10(1.10) 4 = -36.547 1 1 NPVSB = -50 - 20 - = -99.737 3 .10 .10(1.10 ) - 99.737 EAC SB = = -40.106 1 1 - .10 .10(1.10 ) 3 You should take the FinanceRules5000 because it has a lower cost per year. version b 5 FINAL EXAM AUTUMN 2007 BUSINESS FINANCE 3. Provide a brief answer to each of the following questions: [5 each] i.) Explain the relation between growth expectations and P/E ratios. A higher P/E means you are paying a large premium relative to current profit (and profit is a proxy for CF). The only way to rationalize a high P/E is to expect very high future profit. Thus, a higher P/E generally means higher expected growth. ii.) Common stock is called the "residual" claim. Explain why it is called that and what the advantages and disadvantages to having a residual claim are. Common stock is called the residual claim because its only claim is on what's "left-over" after the government (taxes) and bondholders have been paid. That is, if you think of the claimants on the firm's cash flows lining up to collect their portion, stockholders would be at the end of the line, but would get to keep all of what is left over. The major disadvantage is that you are at the end of the line, so there is a chance that nothing will be there for you when it comes time to get your share. The advantage is that all of the growth and profit above what you owe to bondholders is yours. Bondholders do not get paid more if the firm's products do really well. However, the stockholders (as residual claimants) get ALL of the residual, no matter how big it is. iii.) We talked about how the equity beta of a company will always be greater than or equal to the asset beta of a company. As a result, equity holders demand a different return than the return on the assets. In words, explain why is this case (answering "the beta of equity is greater than the beta of assets" is incomplete--you should identify the fundamental differences in risk). Equity holders take on two types of risk: asset (a.k.a. business, or project) risk and financial risk. The asset risk comes from the fundamental nature of the assets underlying the business. The financial risk comes from the fact that the more debt there is in the capital structure, the lower the probability that the equity holders (at the back of the line) will get paid. They demand some extra compensation for the risk of standing at the back of the line. version b 6 FINAL EXAM AUTUMN 2007 BUSINESS FINANCE 4. You are considering the following project: You have just invested $40,000 in the design of a better nose ring. You are now considering the production phase. Production will last for two years and will produce revenues of $60,000 per year and will have costs of $10,000 per year. You will have to buy equipment worth $50,000 immediately and the project requires an initial investment in working capital of $3000 (from zero previously). You must have $2000 worth of working capital at the end of the first year and none when the project is finished. The project's revenues are 5% of overall company revenues and the current annual costs of managing the company are $300,000. You will depreciate the equipment using the straight-line method with a 5-year life to a zero book value. However, you will be able to sell the equipment for $35,000 at the end of the second year. Your tax rate is 40%. Determine all of the incremental cash flows for this project and compute its present value based on a discount rate of 10%. [15] Required Working Capital: 0 Levels Change CF from Change 3000 +3000 -3000 1 2000 -1000 +1000 2 0 -2000 +2000 The current costs of managing the company are irrelevant since they are already being incurred even without the project. The $40,000 you already invested in the design of the better nose ring is sunk and irrelevant. The sale of the equipment will incur taxes since your book value at the end of year 2 will be $30,000 ($50000 minus 2 years of depreciation of $10,000 per year). Your profit (sale price minus book value) is $5000 and taxable. So your net will be $33000 ($35000 5000(.4)). Year +Revenues -Expenses -Depreciation =EBIT Taxes (.40) Net Income Add back Depr Op CF CF from Chg. In WC Capital Expenditures Free Cash Flow -3000 -50000 -53000 35000 0 1 60000 10000 10000 40000 16000 24000 10000 34000 +1000 60000 10000 10000 40000 16000 24000 10000 34000 +2000 +35000-5000(.4) 69000 2 So, the NPV of the project is 53000 + 35000 / (1.10) + 69000 / (1.10)^2 = $35,842.97 5. Assume that George, who is risk-averse but learning the ways of asset allocation, wants to form a two-asset portfolio (50% in each asset). He has the following information on three assets: version b 7 FINAL EXAM AUTUMN 2007 BUSINESS FINANCE Asset A B C E[R] 0.10 0.20 0.20 0.15 0.25 0.25 Correlation between A and B: 0.54 Correlation between A and C: 0.28 Correlation between B and C: 0.91 a) Further assume that George wants a portfolio with an expected return of exactly 15%. Which 2 assets should George choose to make his portfolio? Explain why. (Note: you do not need to precisely calculate portfolio standard deviation.) (4 pts) In order to get an expected return of 15%, he will need asset A combined with either asset B or C. So which would he want? Investors care about return and risk, so since A+B or A+C both have the same expected return, he would want the portfolio with the lowest risk. We know that the only difference between B and C is the correlation with A (they have the same individual ) ... and we know that, as correlation decreases, portfolio risk decreases. So he should choose a portfolio comprised of assets A and C, since that portfolio has lower risk than a portfolio of A and B. b) If the CAPM holds for George's selected portfolio, what would be its beta? The expected return on the market is 15%, and the risk-free rate is 5%. (4 pts) We know that the expected return of the portfolio is 15%. We can look at the return on the market (which is also 15% and has a beta of 1), and determine that since they have the same expected return, they must have the same beta... so the portfolio beta is 1. Or we can solve using the CAPM, with the expected return of 15%: E[ R p ] = rf + p ( rm - rf ) 0.15 = 0.05 + p ( 0.15 - 0.05) 0.15 = 0.05 + p ( 0.10 ) p ( 0.10 ) = 0.15 - 0.05 = 0.10 p = 0.10 = 1.0 0.10 c) If the CAPM holds, is it possible for asset A to have a higher beta than asset B? Explain. (2) No, the expected return for Asset A is lower than B's, hence its beta must also be lower. 6. You know that Eric's opinion is that financial markets (at least in the U.S.) are semi-strong form efficient. But you know that there is ongoing debate on this issue, and you want to gauge the opinions of other people. For each person below, state (in terms of the levels of market efficiency version b 8 FINAL EXAM AUTUMN 2007 BUSINESS FINANCE discussed in class, e.g. "___form") each person's view of market efficiency, and briefly explain your reasoning. (3 pts each) a. Your friendly Starbucks barista: "I think that it's pretty hard to earn higher returns than the market, unless you have some inside information." Semi-strong efficiency: the barista believes that all public information is already incorporated into the stock price. However, abnormal returns can be made with private information, so this does not describe strong form efficiency. b. Your stock broker: "I don't think the history of past prices is enough to succeed. I analyze all of the financial statements, analyst reports and business news that pertain to public companies. Because of this, I can pick stocks that earn higher returns than the market." Weak form efficiency: the broker believes that abnormal returns can be made by analyzing public information, so the broker does not believe that markets are semi-strong form efficient. c. Your uncle: "I find it hard to believe that anyone could consistently beat the market, even if they had insider knowledge." Strong form efficiency: all information (including insider or private information) is already incorporated into the stock price. Even if you had inside information, you could not earn an abnormal return with that information. d. Your high school buddy: "I think that I can look at the patterns of historical stock prices to determine where prices are going in the future. Since I know where prices are going in the future, I can earn higher returns than the market." This person believes that markets are inefficient. Weak form efficiency states that current prices incorporate all information about past prices, but your buddy thinks that abnormal returns can be made just by analyzing past prices. Thus, this person does not believe that markets are efficient in any form. version b 9 FINAL EXAM AUTUMN 2007 BUSINESS FINANCE 7. Your company, Schism, has two divisions. One is a risky high-tech division and the other is a lowrisk retail division selling a well-established product line. You are trying to come up with an appropriate discount rate for the retail division, and have settled on Nordstrom as a comparable company. You notice that Nordstrom has debt totaling $10 billion, market value of equity of $20 billion, a beta of 1.1, and an expected return of 16%. The risk-free rate is 5%. i.) What is the appropriate discount rate that you should use for the retail division? (8) You want to find the asset beta for Nordstrom, to get at the underlying risk of the retail division. You can calculate Nordstrom's asset beta from its equity beta, and use it in the CAPM to find the appropriate discount rate. You also need to use Nordstrom data to find the expected return on the market, rm . E ; (assume D = 0) D+E 20 = 1.1 * = .7333; and to find rm use CAPM , solve 10 + 20 E[rE ] = r f + E ( rm - r f ) .16 = .05 + 1.1(rm - .05) rm = .15 A = E * = 0.05 + .7333( 0.15 - 0.05) = 0.1233 ii.) The CEO of your company has decided that estimating different rates of return for different divisions is hogwash (i.e., nonsense). Therefore, he has a decided on a policy of using the Schism's WACC to evaluate projects in either division. Would the shareholders agree with the CEO regarding this policy? If so, why is it appropriate here? If not, explain exactly what is wrong with this policy, and what kind of errors it would cause. (5) 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-tech division and rejecting some truly positive projects in the retail division. Using this policy, the firm would tend to become riskier over time. finally : E[ rA ] = r f + A ( rm - r f ) 8. What is the difference between an index mutual fund and an actively-managed mutual fund? Is there any reason to believe (or evidence) that an index fund might be a better investment than an activelymanaged mutual fund? Explain. (5) The difference is that the index fund has a pre-specified buy-and-hold investment objective, and holds all the stocks in an index, while the actively-managed fund is buying and selling stocks with the goal of achieving greater returns. There is evidence that suggests that mutual fund managers cannot consistently beat the market returns (as we discussed in class), and the fees for index funds are lower than those for activelymanaged funds (on the order of 0.1 - 0.2% for index funds, compared with 1.5% for activelymanaged funds). Therefore, this suggests that index funds are more likely to be a better investment than actively managed mutual funds. version b 10 ...
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