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SESSION 1 FORMAL EXAMINATIONS – JUNE 2015 EXAMINATION DETAILS: Unit Code:
AFIN253
Unit Name:
Financial Management
Duration of exam:
2 hours + 10 minutes Reading Time
Total no. of questions:
25 Multiple Choice/True False Questions (50 marks) & 5 Full Response Questions (50 marks).
Total no. of pages :
18
INSTRUCTIONS: 1. There are a total of 100 marks available. Marks for each question, or part of a question, are given in parentheses. 2. Record your answers to the multiple choice questions on the General Purpose Answer Sheet using a blue/black pen or 2B pencil. answer ed. 3. All Questions must be answered. 4. Write your answers in the spaces provided. 5. Illegible handwriting risks loss of marks . MATERIALS PERMITTED / NOT PERMITTED: No dictionaries are permitted. A non-programmable non-program mable calculator calcula tor (no text retrieval ret rieval capacity) capac ity) is permitted. permi tted. Financial calculators calculators may be used. One double-sided A4 hand-written sheet may be used. Students are required to hand in all their notes with their exam paper. Mobile telephones must be turned off and left at the front of the room.
Question
Part A
1
2
3
4
5
Total
Out of
50
10
10
10
10
10
100
Mark
•
• •
Candidates are required required to obey all instructions provided by by the Final Examination Supervisor and must refrain from communicating in any way with another student once they have entered the final examination venue. Candidates may not write or mark the the exam materials in any any way during reading time. Candidates may only access authorised materials during this examination. A list of authorised authorised material is available on this cover sheet. If it is alleged you have breached these rules at any time during the examination, the matter may be reported to the University Discipline Committee for determination.
Rough Working Paper
2
Part A Section A The following 10 questions are worth 2 marks each.
1. The systematic risk (beta) of a portfolio is ________ by holding more risk free securities. A) B) C) D)
Decreased Increased Unchanged Cannot say for sure
2. The ________ rate is a price for a currency denominated in another currency. A) B) C) D)
Foreign exchange Reversion Marginal Interest
3. Repurchases and special dividends are useful for making ________ and ________ distributions to shareholders. A) B) C) D)
Large, frequent Large, infrequent Small, frequent Small, infrequent
4. When corporate tax rates decline, the net cost of debt financing A) B) C) D)
Is unchanged Decreases. Increases None of the above
5. Which of the following statements is FALSE? A) A security's beta is the expected percentage change in the return of the security for a 1% change in the return of the market portfolio. B) Securities whose returns tend to move one for one with the market on average have a beta of zero. C) Securities that move less than the market have lower betas. D) Beta represents the amount by which risks that affect the overall market are amplified or dampened in a given share or investment. 6. Because investors can eliminate unsystematic risk 'for free' by diversifying their portfolios, they________ a risk premium for bearing it. A) B) C) D)
Are indifferent about Require Do not require None of the above
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7. Which of the following is NOT a way that a firm can increase its dividend per share? A) B) C) D)
By decreasing its shares outstanding By increasing its dividend payout rate By increasing its retention rate By increasing its earnings (net income)
8. A corner store grocer is contemplating putting a large neon sign over his store. It would cost $50,000, but is expected to bring an additional $24,000 of profit to the store every year for five years. Would this project be worthwhile if evaluated using a discounted payback period of two years or less and if the cost of capital is 10%? A) Yes, since the cash flows after two years are greater than the initial investment. B) Yes, since it will pay back its initial investment in two years. C) No, since the value of the cash flows over the first two years is less than the initial investment. D) Yes, since the value of the cash flows into the store, in present dollars, is greater than the initial investment. 9. An investment will pay $205,000 at the end of next year for an investment of $183,000 at the start of the year. If the market interest rate is 8% over the same period, should this investment be made? A) No, because the investment will yield $6240 less than putting the money in a bank. B) Yes, because the investment will yield $2360 more than putting the money in a bank. C) Yes, because the investment will yield $7360 more than putting the money in a bank. D) Yes, because the investment will yield $4280 more than putting the money in a bank. 10. Which of the following statements is FALSE? A) Bonds typically make two types of payments to their holders. B) By convention the coupon rate is expressed as an effective annual rate. C) Bonds are securities sold by governments and corporations to raise money from investors today in exchange for promised future payments. D) The time remaining until the repayment date is known as the term of the bond.
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Section B The following 5 questions are worth 3 marks each.
11. Michael Morgan has been doing a lot of research about options on the internet as well as from reputable textbooks. He has discovered the following five facts and wishes to know which ones are correct. i) ii) iii) iv) v)
European Options provide more flexibility than American Options. American Options are usually able to be bought at a cheaper price than European options all things being equal. The value of an Option is the sum of its intrinsic value and time value The time value of an option may have little effect on the value of an option in certain circumstances. American options can only be exercised on their maturity date
Which statements above are correct? a) b) c) d)
ii, iii, iv & v i, iii, & iv iii & iv iii & v
12. Mary Zeffer has a keen interest in the factors that impact on the value of an option. A friend of hers, Gerry Song, has provided her with the following information: i) ii) iii) iv) v)
an increase in the volatility of the underlying asset will increase the value of an option A decrease in the value of the underlying asset will decrease the value of an option An increase in the spot (market) price of an underlying asset will increase the value of a put option and decrease the value of a call option An increase in the spot(market) price of an underlying asset will increase the value of a call option and decrease the value of a put option Time value is not relevant to option pricing
Which statements above are correct? a) b) c) d)
i, iii, v i, iv, v ii, iv, i, iv
13. Michael Smith has recently purchased an American call option on BHP. At the time of the purchase the spot price of BHP shares was $55, the exercise price was $53 and the option premium he paid was $2.50. The current price of BHP shares is $56. Which of the following statements is incorrect. a) b) c) d)
The The The The
breakeven price for Michael Smith is $55.50 time value of the option is currently 50 cents intrinsic value of the option is currently $3 intrinsic value of an option can never be negative
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14. Malcolm Noad is interested in the use of a Put to manage the risk in his share portfolio. He has been told a number of things and is really not sure what is true. Which of the following statements in relation to puts is true. a) b) c) d)
A A A A
put will be impacted by the time to maturity the same way a call is long put option is exactly the same as a short call option. put option is suitable only for investors in the Asia-Pacific region. put gives you an obligation to sell the underlying asset.
15. Which of the following statements regarding options is correct? a) b) c) d)
American options may only be traded on the New York Stock Exchange Bermudan options are only available to residents of Bermuda The Black-Scholes-Merton Model of option pricing is named after British singer Cilla Black Options may be bought on both recognized exchanges and OTC.
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Section C True/False Questions The following questions are worth 1.5 marks each. In answering these questions you should choose A for True and B for False on the multiple choice answer sheet provided.
16. Capital Markets theory recommends that a company capital structure is best to be made up of 100% debt 17. An American put option will, all things being equal, have a value less than or equal to a European put option. 18. If financial markets expected interest rates to increase by .25% and they increased by .5% the strength of the Australian dollar should increase 19. If you were quoted a rate of 0.9000 USD / AUD and 1.2 NZD / AUD then the exchange rate for USD / NZD would be 1.333. 20. The CAPM is one of a number of methods available to calculate the cost of equity for an organization. 21. The cost of funding a project should be included in a capital budgeting analysis where the interest is repaid within the term of the project duration. 22. The dividend discount model used in share valuation assumes that all dividends are constant over time. 23. The intrinsic value of a call option can be defined as Max(spot – exercise, 0). 24. If a company issued a special class as equity whereby dividends were treated as an interest expense by the tax office and thereby attracted a tax deduction, it would be necessary to multiply the return by (1-tax rate) when including it in any after tax weighted average cost of capital calculation. 25. If you were told by your best friend that sunk costs and opportunity costs were the same thing you would think your friend was incorrect.
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Part B Short Answer Questions (50 Marks) Question 1 (10 Marks) Semilon Ltd is a company funded by a mixture of debt, equity and preference capital. The marginal tax rate of Semilon is 30%. The company expects to pay a dividend of $2 next year and achieve a growth rate of 3%. The current market price of the share is $12 and the Beta of the stock is .7. There are currently 1 million shares on issue. The company also has debt with a maturity of 5 years that pays annual coupons. The coupon rate is 6% and the bond was issued with a face value of $1000 and is currently priced at $1000. There are presently 6000 bonds on issue. Preference shares have a face value of $100 and pay an annual dividend of 8%. The current market price of the preference share is $80. When the share was issued at face value the value of the stock issued was $2m.
(a) Calculate the weights of the ordinary shares, bonds and preference shares that would be used in a WACC calculation for Semilon Ltd. (2 Marks)
Market value of ordinary shares: 1m*$12=$12m Market value of debt: $1000*6000=$6m Market value of preference shares: $2m/$100*$80=$1.6m Total value of company: $12m+$6m+$1.6m=$19.6m (1 mark) Weight of ordinary shares: $12m/$19.6m=61.22% Weight of debt: $6m/$19.6m=30.61% Weight of preference shares: $1.6m/$19.6m=8.16% (1 mark)
(b) Calculate the cost of equity of the ordinary shares.
Cost of equity=D1/P0+g=$2/$12+3%= 19.67%
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(2 Marks)
(c) Calculate the cost of debt on an after tax basis.
(2 Marks)
After-tax of debt=Before-tax of debt*(1-tax rate)=6%*(1-0.3)=4.2% (2 marks for correct after-tax cost, and 1 mark for pre-tax cost only)
(d) Calculate the cost of equity of the preference shares.
(2 Marks)
Dividend=$100*0.08=$8 Cost of preference shares=$8/$80=10%
(e) Calculate the WACC on an after tax basis.
WACC=61.22%*19.67%+30.61%*4.2%+8.16%*10%=14.14%
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(2 Marks)
Question 2 (10 Marks) Toblerone Ltd is a leading manufacturer of Swiss Clocks but is looking to expand into the production of watches. A business opportunity has presented itself and has the following cash flows. Period 0 Period 1-3 Periods 4 – 6 Periods 7-9 Period 10
-$5m USD 0 $1m USD per year $2m USD per year $4m USD.
The discount rate used by the company is 8% per annum. a) Calculate the payback period. If the company accepts all projects with a payback less than 8 years should the project be accepted? (2 Marks) Use the following table to assist in calculating your answer (Show all working)
Cash flows
Cumulative cash flows
0
-5m
-5m
1
0
-5m
2
0
-5m
3
0
-5m
4
1m
-4m
5
1m
-3m
6
1m
-2m
7
2m
0
8
2m
2m
9
2m
4m
10
4m
8m
Year
Payback period=7 years 7 years<8 years, accept the project. (1 mark for correct payback period, 1 mark for accept/reject based on earlier answer.)
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b) I) Calculate the discounted payback period. If the company accepts all projects with a discounted payback less than 8 years should the project be accepted? (2 Marks) II) Calculate the cash flow required in year 10 for the project to have a zero NPV (2 Marks)
Use the following table to assist in calculating your answer (Show all working)
Present values of cash flows
Cumulative cash flows
0
-5m
-5m
1
0
-5m
2
0
-5m
3
0
-5m
4
1m/1.08^4=0.735m
-5m+0.735m=-4.265m
5
1m/1.08^5=0.6806m
-4.265m+0.6806m=-3.5844m
6
1m/1.08^6=0.6302m
-3.5844m+0.6302m=-2.9542m
7
2m/1.08^7=1.167m
-2.9542m+1.167m=-1.7872m
8
2m/1.08^8=1.0805m
-1.7872m+1.0805m=-0.7067m
9
2m/1.08^9=1.0005m
-0.7067m+1.0005m=0.2938.m
10
4m/1.08^10=3.7003m
1.0516m+3.7003m=4.7519m
Year
(i) Discounted payback period=8+0.7067/1.0005=8.706 years 8.706>8, reject the project (1 mark for correct payback period, 1 mark for accept/reject based on earlier answer.)
(ii) 0=0.2938m+CF(10)/1.08^10, CF(10)= - 0.634m
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c) The head of finance has informed you that “any project with a payback of less than 8 years is guaranteed to generate shareholder wealth”. Is she correct? (1 Mark) Why or Why not? (1 Mark) How would you respond to such a statement? (2 Marks) • • •
Solution: • •
•
She is incorrect. (1 mark) The project may have large negative cash flows in the later years, which will harm shareholders’ interests because the NPV of the project can still be negative. (1 marks) In addition to payback period, we should consider other capital budgeting methods to evaluate a potential project, such as NPV and IRR. Payback periods gives us some useful information, but since it ignores the cash flows after the payback time, we should never make a decision based solely on that. (2 marks)
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Question 3 (10 Marks) a) Assume the market can have five possible states: very good, good, neutral, bad and very bad. The probabilities for each of the states are given in the table below, and so are the returns of two assets, Asset 1 and Asset 2 for each of these states:
(i)
State
Probability
Asset 1 returns
Asset 2 returns
Very good
0.1
14%
8%
Good
0.2
8%
5%
Neutral
0.4
2%
2%
Bad Very bad
0.2 0.1
-4% -10%
-4% -8%
Calculate the expected return of Asset 1 and Asset 2. Using the two assets, how could you construct a portfolio with expected return of 1.7%? (2 Marks)
Expected return of asset 1=0.1*14%+0.2*8%+0.4*2%+0.2*(-4%)+0.1*(-10%)=2% (0.5 mark) Expected return of asset 2=0.1*8%+0.2*5%+0.4*2%+0.2*(-4%)+0.1*(-8%)=1% (0.5 mark) W=weight of asset 1 W*2%+(1-w)*1%=1.7% (0.5 mark) Weight of asset 1=70% Weight of asset 2=30% (0.5 mark)
(ii)
Calculate the standard deviation of returns for Asset 1.
(2 Marks)
Variance of asset 1 =0.1*(14%-2%)^2+0.2*(8%-2%)^2+0.4*(2%-2%)^2+0.2*(-4%-2%)^2+0.1*(-10%-2%)^2 =0.00432 (1 mark) SD1=0.06573 (1 mark)
(iii)
Assuming that the standard deviation of Asset 2 is 1% and the correlation between returns from Asset 1 and Asset 2 is !=0.94, what is the standard deviation of a portfolio with equal weights w 1= w2=0.5? (4 Marks)
Variance of portfolio= 0.5^2*0.01^2+0.5^2*0.00432+2*0.94*0.5^2*0.01*0.06573=0.001434 SD of portfolio = 0.03786 (No deduction of mark for carried-on errors)
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b) The CAPM describes the relationship between risk and expected return of a particular asset. Explain why we choose to use beta instead of standard deviation to measure risk in the model. (2 Marks) •
•
Standard deviation measures the asset’s total risk while beta measures its systematic risk. (1 mark) In the CAPM model, idiosyncratic risk is irrelevant because it can be diversified away. The expected return of the asset is only based on its systematic risk, so we should use beta instead of standard deviation as the measure of risk. (1 mark)
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Question 4 (10 Marks)
a) Explain how a trader could use forward rates to earn a profit in the foreign exchange market. (4 marks)
•
•
•
A forward contract enables the trader to buy/sell currencies at a pre-determined exchange rate. (1 mark) If the forward exchange rate is different from the spot exchange rate, the trader can enter into a forward contract as the buyer/seller of a currency to earn a determined return. (1 mark) The annualised return is: Forward premium/discount=(forward rate-spot rate)/spot rate*(360/90) (2 marks)
b) Describe the process of ‘International Capital Budgeting’. Describe three factors and difficulties other than exchange rate risk that need to be taken into account in the decision-making process for evaluating overseas capital projects? (6 marks) •
•
•
Most companies find it more difficult to estimate the incremental cash flows for foreign projects. (2 marks) Problems with cash flows can arise when foreign governments restrict the amount of cash that can be repatriated, or returned, to the parent company. (2 marks) Country risk: If a company is located in a country with a relatively unstable political environment, management will require a higher rate of return on capital projects as compensation for the additional risk. (2 marks) Nationalisation o Changes in tax laws o Tarriffs and quotas on imports o (Up to 4 marks can be given if the students only focus on the discussion of country risk)
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Question 5 (10 Marks) Grace Kang Ltd sells jigsaw puzzles for $50 per puzzle. With the current production technology, the total fixed costs are $17,500,000 per annum, and the depreciation and amortisation for the company is $5,000,000. It costs $10 to produce one puzzle and the forecast sales next year will be 1,500,000 units. The company is considering changing its production technology. Sales are expected to be the same regardless of which production technology the company chooses. However, if a new production line is adopted, the fixed costs will increase to $20,000,000, and the variable cost per unit will be reduced to $7 per puzzle. Assume the depreciation and amortisation expense is unchanged. a) Use the above information to calculate the accounting DOL for the current technology as well as the new technology. (4 Marks) DOL=1+(FC+D&A)/EBIT, EBIT=revenue-FC-VC-D&A
EBIT_1=50*1.5m-17.5m-10*1.5m-5m=37.5m DOL_1=1+(17.5m+5m)/37.5m=1.6 EBIT_2=50*1.5m-20m-7*1.5m-5m=39.6m DOL_2=1+(20m+5m)/39.5m=1.6329
b) Which technology has a higher accounting DOL? Compare the two technologies and explain why that is the case. (2 Marks)
The new production technology. Since it has a higher proportion of fixed cost, the accounting profits should be more sensitive to changes in revenue.
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c) Calculate the EBIT break-even points for both technologies.
(2 Marks)
EBIT breakeven=(FC+D&A)/(price-unit VC) Breakeven_1=(17.5m+5m)/(50-10)=562,500 Breakeven_2=(20m+5m)/(50-7)=581,395
d) What is the number of puzzles for which the cash flow operating profit is the same, regardless of the technology choice? Calculate the crossover level of unit sales for EBITDA. (2 Marks)
CO(EBITDA)=(FC_1-FC_2)/(UV_1-UC_2) =(20m-17.5m)/((50-7)-(50-10)) =833,333
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Rough Working Paper
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