EXAMINATION FOR

125.330 ADVANCED BUSINESS FINANCE

Semester One 2018

Section A: Answer Questions 1-20 on the Multiple Choice Answer Card. For each question, select the one best answer.

1.       Which of the following statements concerning capital budgeting is NOT true?

A.       It makes sense for smaller businesses to use payback period method as it deals with time value of money well.

B.       NPV and IRR can lead to the different conclusion in choosing between mutually exclusive projects.

C.       A  project  with  zero  NPV  provides  an  average  return  that  will  just compensate for the risk taken.

D.       The reinvestment rate typically assumed in NPV calculation is the cost of capital or the hurdle rate itself.

E.       Among all capital budgeting tools, NPV is the most consistent with the Value Based Management (VBM) principle.

2.       Which of the following scenarios is appropriate to use WACC as the discount rate in the NPV analysis?

A.       Bruno is considering an introduction of the new (but similar) products of the company to the existing customers.

B.        Ed is evaluating entering a new industry to diversify the company’s risk.

C.       Sade is considering a speculative venture with a company’s Japanese supplier.

D.       Angela is looking into the project that will improve cost management with known technology within the company.

E.        Rebecca is evaluating whether buying a stock based on its current price will add to her wealth.

3.        The book value and market value of equity for XYZ Company is $200,000,000 and $300,000,000 respectively. The company has 1,000,000 shares outstanding and the current share price is $300. The long-term debt of the company is recorded as $600,000,000 (book value and market value equal). The company’s net income is $20,000,000. What is the ROA of the company?

A.       5 %

B.       3.33%

C.       2.5%.

D.       1.5%

E.       None of the above

4.       What is the EAC of a project that has the present value of cost of $1 million through its 10 year life time? The discount rate involved is 7%.

A.       $142,377.1

B.       $153,769.3

C.       $167,824.4

D.       $175,093.5

E.       None of the above

5.       A project causes the company to increase the working capital balance to

$10,000 during the first year of its operation. The balance of working capital is projected to decrease by 10% each year. The project will last for three years. What will be the cash flows from ‘changes in working capital’ at the end of year three?

A.       Cash outflow of $12,100

B.       Cash inflow of $12,100

C.       Cash outflow of $8,100

D.       Cash inflow of $8,100

E.       None of the above

6.       The cost of equity is 10% and the cost of debt 6%. Assuming that the target  debt / equity ratio is 3 (in market value term) and 2 (in book value term), and the company tax rate is 30%, calculate the overall cost of capital for the company if interest expense CANNOT be used for corporate tax saving purpose.

A.       5.65%

B.       6.00%

C.       6.80%

D.       7.55%

E.        None of the above

7.       Which of the following is associated with the lowest cost of capital for a firm?

A.        Internally generated funds (e.g. retained earnings)

B.        Long-term bond

C.       Preference shares

D.       Ordinary shares

E.       Call options

8.       All else equal, an increase in operating leverage would:

A.       increases the break-even point based on NPV and decreases the accounting break-even point.

B.       decreases the break-even point based on NPV and decreases the accounting break-even point.

C.       increases the accounting break-even point and decreases the break- even point based on NPV.

D.       increases the break-even point based on NPV and increases the accounting break-even point.

E.       None of the above.

9.        You run a CAPM regression on a listed company and find the beta to be 1.5. The entire long-term financing of this firm is 100 million dollars, of which 80 million dollars of this figure represents long-term debt. The rest is equity. What is the beta which reflect the business risk of this company?

A. 0.3

B. 0.5

C.        0.7

D.       1.5

E.       None of the above

10.     Which of the following statements is not true?

A.       Assets with larger betas are more sensitive to idiosyncratic risk.

B.       The market portfolio has a beta of one (Beta = 1).

C.       The slope of the SML line is the market risk premium (Rm - Rf).

D.       Beta of an asset can be negative.

E.        In the context of SML, the expected return of a share with a beta of 0.96 will be lower than the expected return of the corresponding stock market.

11.     Which of the following is not true regarding financial ratio analysis?

A.       The quick ratio of a company will always be lower than its current ratio

as long as the company’s inventory balance is positive.

B.       If the short-term assets of a firm are equal to its current liabilities, the net working capital is negative and the current ratio is equal to zero.

C.       Return on Assets (ROA) is not sensitive to the firm’s stock price.

D.       Market-to-book (M/B) ratio compares the market price of the

company’s share to the company’s book value of equity per share. The higher, the more expensive the company’s share is.

12.     According to the pecking order of financing choices theory:

A.       there is the optimal capital structure that a company targets for.

B.       the extent of debt usage in a firm decreases with its profitability.

C.       the interest tax shield increases the firm value.

D.       the bankruptcy costs decrease the firm value.

E.       the existence of creditors reduces agency problems.

13.     Which of the following financial ratios has no effect on the profitability of the firm, according to the Modified Du Pont system?

A.       Total Assets Turnover

B.       Profit Margin

C.       Current ratio

D.       Equity Multiplier

E.       All of the above matter.

14.      Daimaru Department Store Company is purely financed  by Common stock that is priced to offer an average return of 10% per year. Following the new CEO’s direction that the  company will become financially aggressive, the company repurchases 80% of the stock and substitutes an equal value of debt yielding 7%. In the context of Modigliani and Miller, what will be the expected return on the common stock of this company after refinancing, in the world without taxes?

A.       32%

B.       28%

C.       22%

D.       20%

E.       None of the above

15.     A debt-free firm produces a constant (assumed to go on indefinitely) EBIT of $100,000, each year with the cost of capital of 16%. The value of this firm is

. If the firm decides to borrow one million dollars on a ten-year loan from the  bank at 8%  interest  rate, the value  of the firm will  become

: Corporate tax rate is 20%.

A.       $500,000; $123,547

B.       $500,000; $607,362

C.       $625,000; $777,217

D.       $625,000; $850,200

E.       None of the above

16.     Which of the following is not true regarding levering and unlevering beta?

A. βLevered ≥   βUnlevered

B.       Beta from running a CAPM regression is unlevered beta.

C. βUnlevered  represents business risk.

D.       In deriving Levered Beta equation, Beta of debt is assumed as ‘0’ .

E.        In deriving Levered Beta equation, Beta of interest tax savings is

assumed as βUnlevered.

Firm A has proposed to acquire Firm B at a premium by paying $5 per share over Firm B's current stock price. Calculate the NPV of the merger.

A.       - $20 mil

B.        $0

C.       $10 mil

D.       $20 mil

E.        None of the above

Please answer the following question based on the assigned article of Module 5: “Corporate governance and risk-taking in New Zealand” by Koerniadi, Krishnamurti, and Tourani-Rad, published in the Australian Journal of Management (2013):

18.     Which of the following is NOT true regarding corporate practice/behaviours in New Zealand?  (JEFF TO COVER)

A.       Management of NZ public firms do not receive effective disciplinary

actions from the capital market due to its inactive takeover market.

B.       Ownership  concentration  (e.g  dominated  shareholders)  is low due to larger capitalisation among listed firms.

C.       Performance-based compensation for management (e.g. stock option) is not widely used

D.       Overall, NZ public firms are relatively passive in their risk-taking.

E.       Block holdings enhance risk-taking activities among NZ public firms.

[Total: 2.5 marks each = 45 marks]

SECTION B:  Answer Questions  19, 20, 21, 22, and 23 in the answer booklet. Show all your workings. Write clearly (e.g. readable handwriting).

19.     ABC Company issues a two-stage-coupon perpetual bond with the total par value of $100 million. The coupon rate (paid once a year with the first coupon payment one year after issuance) set for the first ten years is 5 percent. After that, the coupon rate will jump to 7%. The YTM of this bond is 10%. Assume a 20 percent marginal corporate tax rate.

Required

Calculate the the present value of the interest tax shield to ABC Company based on this bond. [Total: 8 marks]

20.     An introduction of a new product (the project) requires an initial investment of 25 million dollars. However, it takes one year before production can start (e.g. no cash flow during the first year). Starting in the second year, the project will allow the company to produce 200,000 units of product (all can be sold) each year. The variable cost per  unit is $65. The project will last for 12 years (counting from time t=0). Assume no salvage value and no corporate tax rate. The discount rate that reflects the riskiness of this project is 9% per year.

Required

Calculate  the  ‘ price  per unit’ of the new product that will yield the ‘financial break-even’ point. [Total: 7 marks]

21.     After  spending  $3 million on research and feasibility study, Supreme  Filters has developed a new water filter product. To launch this new product, an initial investment in fixed asset of $6 million is required. This initial investment will be depreciated using the straight line method over five years, down to zero value. However, this fixed asset can be sold for $500,000. Working capital needs to be  maintained at 10% of next year  forecasted  sales. Production  cost is estimated at $1.50 per filter (unit) while each filter can be sold for $ 4.00. Corporate tax rate (and also capital gain tax) is 35%. The discount rate of return that applies to this project is 12%. Sales forecasts are given as follows:

Year       Sales (millions of filters)

1              0.5

2             0.6

3             1

4             1

5             0.6

Required:

Calculate how much the introduction of the new filters will add or subtract the company value. [Total: 18 marks]

22. Real option - A venture capitalist is considering taking a  10 year project that requires an initial investment of $10 million in new product partnership. As of now, the expected PV of this project is estimated as only $9.5 million. Clearly, the project is out-of-the-money at the moment. Nevertheless, what’s special about this project is the agreement that he can sell his share of the ownership to other partners anytime in the next 10 years (t = 10), for $7.5 million. The variance in the PV of cash flows from being in the partnership is high and calculated as 0.09. The 10-year risk-free rate is assumed as 3% per year. (Rf = 0.03). Assume that the project does not depreciate over time.

N(1.0397) = 0.8508

N(1.1495) = 0.8748

N(1.3578) = 0.9127

N(0.4582) = 0.6766

N(0.0911) = 0.5363

N(0.0547) = 0.5218

N(0.0288) = 0.5115

N(d1=?) = 0.90

N(d2=?) = 0.55

Note: In the case you could not find N(d) that matches your d1 and d2, please  use  N(d1=?)  and  N(  d2=?).  However,  please indicate exact numbers you get for d1 and d2.

Required:

Calculate  the  value  of  real  option  to  abandon  the  project  for  the  venture capitalist.  Is  the  value  of  real  option  high  enough  to  compensate  for  its negative NPV? [Total: 16 marks]

23.     Based on the two articles assigned for Module 4:  (JEFF TO COVER)

1. “Capital Structure Instability” by Harry DeAngelo and Richard Roll (Journal of Applied Coporate Finance, 2016).

2. “ Proactive leverage increase and the value of financial flexibility” by David Denis and Stephen McKeon (Journal of Applied Corporate Finance, 2016).

Please concisely answer the following:

Required

1)  Briefly  explain  WHY  ‘financial  flexibility’   is  critical  for   businesses,  as mentioned in the above articles.   (3 Marks)

2)   Following  from  the  above,  briefly discuss whether firms that proactively issue equity (and  hold excess cash) are  MORE or  LESS  risky.  Please make sure you clearly explain why.  (3 Marks)

[Total:6 marks]