Introduction to Managerial Finance, FINE 5200 G/X

Winter 2016
Sample Final Exam
Professor Yelena Larkin
Part 1: Multiple choice [40%, 2 points each; 1 hour]
Partial credit will be awarded in Part 2 so be sure to show all work and
explain your answers. If you run out of time or get stuck with the math,
write down how you would proceed with the problem. You may bring a
calculator and two sheets of paper (both sides) for formulas and reference.
This examination is 3 hours. The times given for the questions add to 2 hours
and 30 minutes giving you 30 minutes of slack time. Good Luck!

1. Which of the following is/are true for a stock with beta equal to
1.5?
I.
II.
III.
A.
B.
C.
D.
E.

The stock has a 50% higher expected return than the average stock
Given a market risk premium of 10%, the expected return on the
stock
would the 15%
The stock has 50% more systematic risk than the average stock.

I only
II only
III only
I and III only
I, II, and III

Statements (I) and (II) are wrong because one should account for risk-free
rate as well, which is part of the SML line. If risk-free rate is positive, the
statements are wrong.
2. Ajax Corp. has been operating as three separate divisions over
the past ten years, although all capital budgeting decisions are
ultimately made at the home office using the firm's overall WACC.
Just recently, they discovered that the divisions have significantly
different risks. Which of the following is also likely to be true?
A. The divisions are being rewarded for decreasing their risk.

B. Higher earning divisions will be less risky than the lower earning
divisions.
C. Its low earning division tends to be ignored in capital allocation even
though it tends to maintain lower levels of risk.
D. The differences in risk among the divisions have no impact on the
capital budgeting process.
E. The highest divisional cost of capital will approximately equal the
firm's overall cost of capital.
In this case the company is making an error of rejecting good NPV
opportunities for the low-risk division because it is using higher discount rate
than the one that should be used.
3. Which of the following is true concerning diversification? Assume
that the securities being considered for selection into a portfolio
are not perfectly correlated.
A. The risk of the portfolio is certain to be increased as securities are
added.
B. As more securities are added to the portfolio, the market risk of the
portfolio declines.
C. After about 10 securities are added to the portfolio, additional
securities
have
no
impact
on reducing risk.
D. As more and more securities are added to the portfolio, the level of
risk
approaches
the
level of systematic risk in the market.
E. If you hold more than 100 securities, then the portfolio is risk-free.
This is the idea of diversification as you add securities to the portfolio,
the total risk will decrease due to the decline in non-systematic risk
4. If the only information from the statement of comprehensive
income items known to you are net income and depreciation,
which of the following methods for calculating project OCF would
you use?
I.
II.
III.
A.
B.
C.
D.
E.

Bottom-up approach
Top-down approach
Tax-shield approach

I only by definition of the approach

II only
III only
I and II only
I and III only

5. 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%.
Furthermore, we know that stock A is fairly priced and that the
betas of stocks A and B are correct. Which of the following
regarding stock B must be true?
A.
B.
C.
D.
E.

Stock B is also fairly priced.

The expected return on stock B is too high.
The expected return on stock A is too high.
The price of stock B is too high.
The price of stock A is too high.

If stock A is fairly priced, then: 13.5=7+1.2*(Rm-rf) (Rm-rf)= 5.412%

The required return of B should be: E(RB)=7+0.8*5.412=11.33%
In this case 11.33%>11% - the expected return is insufficient compensation
for the risk exposure the stock price is too high (remember that there is an
opposite relationship between price and return)

6. At an interest rate of r>0, which of the following cash flows

should you prefer?
Year 1
A.
B.
C.
D.

500
100
300
Any of

Year 2

Year 3

300 100
300 500
300 300
the above, as they all add to $900

Because of the time value of money its always better to receive larger
payments earlier

7. A financial manager reviewing a project is concerned about the

level of forecasting risk in the project's estimated cash flows.
The manager should use ___________ to identify the variable that
presents the highest degree of forecasting risk.
A. Scenario analysis

B.
C.
D.
E.

Simulation analysis
Sensitivity analysis
EAC formula
Payback rule

8. You discover that you can make greater than expected returns by
buying
stock in firms whenever the growth rate in sales predicted by an
investment survey exceeds the stock's current price-earnings
ratio. Which of the following best describes this event?
A. This would not be a violation of market efficiency.
B. This would be a violation of semi-strong form efficiency but not of
strong form efficiency
C. This would be a violation of strong form efficiency but not of semistrong form efficiency.
D. This would be a violation of all forms of market efficiency.
According to any form of market efficiency, all the relevant past
information should be incorporated in the prices.

9. Over the last four years you earned -15%, 50%, 20%, and 10%.
What is the standard deviation of your returns?
A. 0.87%
B. 7.23%
C. 10.34%
D. 20.73%
E. 26.89%
First, find expected return: E(R)=0.25*(-15%)+0.25*50%+0.25*20%
+0.25*10%=16.25%
After that, calculate variance:
Var(R)= 0.25*(-15%-16.25%)2+0.25*(50%-16.25%)2+0.25*(20%16.25%)2+0.25*(10%-16.25%)2=0.0723
From here, take the square root to get standard deviation=26.89%
10. Your neighbor is complaining that not only is the market
interest rate on his bond dropping but so is the coupon rate. You
know he must own
A. A zero coupon bond.

B.
C.
D.
E.

An inverse floater
A convertible bond
A government bond
A floating rate bond coupons are adjusted to some index, typically
market interest rate

11. Martins Method Acting School has a current ratio of 2, a quick

ratio of 1.8, net income of $180,000, a profit margin of 10%, and
an accounts receivable balance of $150,000. What is the firms
average collection period?
A.
B.
C.
D.
E.

50
43
30
24
16

days
days
days
days
days

Profit margin=NI/Sales Sales=$180,000/10%=$1,800,000

Receivables turnover=Sales/AR=$1,800,000/$150,000=12
Days sales in receivables=365/ Receivables turnover=365/12= 30 days

12. Energistics Inc. plans to retain and reinvest all of its earnings
for the next three years. At the end of year 3, the firm will pay a
special dividend of $5 per share. Beginning in year 4, the firm will
begin to pay a dividend of $1 per share, which is expected to
grow at a 3% rate annually forever. Given a required return of
12%, the stock should sell for ___ today.

A.
B.
C.
D.
E.

$11.47
$12.44
$13.15
$14.27
$15.01

Discount $5 in year 3 separately: PV=5/(1+0.12)^3=$3.56

PV*(Dividend stream that starts in t=4)=1/(0.12-0.03)=11.11
PV*=FV(t=3) PV=11.11/(1+0.12)^3=$7.91

P(stock)=$7.91+$3.56=$11.47

13. If CAPM holds and two stocks have the same standard
deviation (SD) it means:
A.
B.
C.
D.

Its impossible
The two stocks have the same beta
The two stocks have the same correlation with the market
The two stocks can still have difference betas and correlations with the
market

In CAPM world two stocks with the same beta have to have same expected
return. Everything else can vary.
14. Which of the following cases is impossible according to the
CAPM model?
A.
B.
C.
D.

Stock with negative beta

A stock with SD>0 and beta=0
A stock with SD=0 and beta>0
All of the above cases are impossible according to the CAPM

A risk-free asset should have beta=0

15.

If a project has a NPV>0, then:

A. The IRR of the project is also greater than zero.

B. A decrease in the projects initial cost may cause the project to have a
negative NPV.
C. An increase in the projects net working capital cost may cause the
project to have a negative NPV.
D. None of the above
Increase in NWC reduces FCF may cause the project to become unprofitable

16.

If IRR(Project A)>IRR(Project B) then:

A. Project A is always better than project B.

B. Project A is better than project B as long as both IRRs are positive.
C. Project A is better than project B as long as both projects have
conventional cash flows.
D. It is possible that project B is better than project A.
Even for conventional projects, the NPV may differ depending on the slope of
the required return-NPV line.
17.
The EAC method for evaluating projects applies when which of
the
following project characteristics exist?
I. The projects are mutually exclusive.
II. The projects have different economic lives.
III. The projects will be replaced more or less indefinitely.
A.
B.
C.
D.
E.

III only
I and II only
I and III only
II and III only
I, II, and III

18. Which one of the following statements concerning forward

contracts is true?
A. Forward contracts are marked-to-the market daily.
B. Forward contracts can become very expensive in volatile market
environment.
C. Both the buyer and the seller of a forward contract can profit if both
parties hold the original contract for the duration of the contract.
D. The buyer of a forward contract has the right, but not the obligation, to
take delivery of the goods.
E. The seller of a forward contract on corn profits when the price of corn
falls.

19.

You are considering two option contracts with the same strike

price. Ignoring costs, which one of the following combinations will

increase the value of your portfolio if prices move either up or
down?
A.
B.
C.
D.
E.

Buying both a call and a put.

Both buying and selling a call
Buying a call and selling a put
Buying a put and selling a call
Both selling a put and a call

20. A firm is considering a project that is virtually risk-free. The

company has a beta of 1.3 and a debt-equity ratio of .4. The
appropriate discount rate to use in analyzing this project is:
A.
B.
C.
D.
E.

The firm's latest WACC.

An adjusted WACC based on a beta of 1.0.
The cost of equity capital.
The Treasury bill rate.
Zero.

Any project should be evaluated based on the risk of the project itself, and
not the risk of the company that is implementing it. Also, in the CAPM world
beta is the appropriate measure of risk, so a risk-free project should be
discounted using risk-free rate.

Part 2: Problems [60 %, 1 hour and 30 minutes]. Partial credit will

be awarded in this section. Please be sure to show all work and

explain your analysis.
Question 1 (25%, 30 minutes) :
John Chen won $1.2 million U.S. in the Florida state lottery. John will
receive the money in 20 equal annual installments at the end of each
year with the first installment of $60,000 U.S. due one year from today.
At todays exchange rate the installments are worth $88,235 Cdn.
Assume that lottery winnings are not subject to taxes.
Yesterday, John received a phone call from a Canadian brokerage firm
offering to buy the rights to his future prize installments for a lump
sum of $820,000 Cdn. in cash today. The broker also promised John a
return of 18% with low risk if he invests some of the lump sum
payment with the firm.
A. If John decides to go with the brokers offer, he plans to buy a Porsche
for $170,000 Cdn. and to pay off the mortgage on his house for
$125,000 right away. Assuming that the broker indeed generates
annual return of 18%, can he afford those expenses if he also wants to
invest the rest of the lump sum amount with the broker to generate
$88,235 Cdn. a year?
B. Draw on your knowledge of financial markets to discuss whether the
investment executives proposal of generating return of 18% with low
risk is realistic.
C. Solely from the perspective of time value of money, which option is
better? In your answer, you can use return of 18% if you have
answered yes to (b), or a rate of return that you consider realistic if
you have answered no (in this case, you need to provide a brief
justification to your choice).
D. Discuss the exchange rate risk associated with each of the alternatives
open to John and state which is better viewed solely from the
perspective of minimizing exchange rate risk. If John were to choose
an alternative open to exchange rate risk, how would you recommend
that he hedge this risk with a derivative security? Explain your choice
briefly.
E. Should John take the lump sum? Should he invest with the investment
executive? Explain briefly based on your answers to (c) and (d).

a.Assuming that the investment executive can deliver on his promise of an

18% return with low risk, evaluate Johns financial plan. Is his plan feasible?
Assuming an 18% return on investments is feasible:
PV (annuity) where T=20; C=88,235; r=18% = $472,230
John can invest the amount and earn $88,235 each year.
Balance to spend = $820,000 - $472,230 =$347,770
Plan to spend $170,000 + $25,000 = $295,000
So plan is feasible

Alternate answer:
$820,000 - $170,000 - $125,000 = $525,000 to invest at 18%
Generates $98,080/year for 20 years @ 18% so plan is feasible as this
exceeds $88,235

b.Draw on your knowledge of financial markets to discuss the advantages

and disadvantages of the investment executives proposal.

Investing in equities is not low-risk! 18% is too high for equities unless they
are very high risk.
Todays T-bill rate is around 3.5%
Historical market risk premium = 7%
Forward looking market risk premium = 3%
Expect on average Canadian equities: 6.5 10%. Not 18%
Conclude: Investment executive is unrealistically optimistic. Johns plan is a
pipe dream.

c. Solely from the perspective of time value of money, which option is better?
In your answer, you can use return of 18% if you have answered yes to (b),
or a rate of return that you consider realistic if you have answered no (in
this case, you need to provide a brief justification to your choice).

Using r=8% (roughly middle of the range in the answer in (c)) the PV
changes to 866K already not worth choosing the lump sum.

d.Discuss the exchange rate risk associated with each of the alternatives
open to John and state which is better viewed solely from the perspective of
minimizing exchange rate risk. If John were to choose an alternative open to
exchange rate risk, how would you recommend that he hedge this risk with a
derivative security? Explain your choice briefly.

Lump-sum: No FX risk. Canadian dollar, now living in Canada.

Decline lump-sum. Receive $60,000 US annually. FX exposure if Canadian
dollar strengthens. US $60,000 less than $88,235 Canadian.
To minimize FX risk, prefer lump sum.
If choose payments, need to hedge.
Currency swap: John pays US $ to receive Canadian advantage. Can be
tailored to long-term.
Could also set up a series of forward purchases of Canadian/sales of US, also
OTC.

Hedging with exchange traded derivatives: futures or currency future options

possible, but would have to roll hedge or they are short term.
d.Should John take the lump sum? Should he invest with the investment
executive. State your recommendation to John and explain briefly.
Definitely, do not invest with the investment executive. His pitch is
misleading. Could take lump sum to have cash now if he is willing to spend
less in the future or keep working.

Question 2 (20%, 30 minutes)

Reitmans Ltd. bought a distribution facility 3 years ago for $8 Million.
It can sell the facility today for $7 Million. If the facility is not sold, it
will produce pre-tax annual earnings of $2 Million for the next 3 years.
At the end of 3 years, Reitmans will need to get rid of the facility, since

by that time it will be so worn out that it will not meet the safety
standards and will have to be demolished (ignore demolition costs).
Due to an old special arrangement with the municipality, the company
does not own the land on which the facility is currently is located, so
that after the demolition the value of the facility will essentially be
zero).
Another option is to replace the facility today, by spending $10 Million
on a new facility. Since the facility will be larger, it will produce pre-tax
earnings of $3.2 Million for the next 6 years at which time it will be sold
for $1 Million.
Assume straight line depreciation for all the assets. Both assets are
depreciated over 6 years with no salvage value. The tax rate is 15%.
The required rate of interest is 7%.
Which option is better? Show all of your calculations.
Old facility: Dep=(8-0)/6=1.33; BV(today)=8-1.33*3=4; Proceeds=7-(74)*15%=6.55

Additional calculation: proceeds from asset sale of the new building in year 6
Proceeds=1-(1-0)*15%=0.85

NPV(old facility option) = $4.99 million (discount separately, or use annuity of 3

periods)
NPV(new facility option) = $11.27 million (use annuity of 5 periods, plus discount
separately CF in period, 6 plus CF today)
Note that in this case NPV is sufficient, since the first option cannot be rolled over.
Therefore, you should pick the highest NPV (profit maximizing problem) sell old
facility.

Question 3 (15%, 30 minutes)

Owens Terrell Corporation (OTC) is contemplating borrowing money

for a five year period. Eli & Peyton (E&P) is a family business also
considering borrowing for five years. Suppose that:

A. E&P can borrow fixed at 330 basis points (bp) and can borrow
variable at LIBOR
B. OTC can borrow fixed at 350 bp and variable at LIBOR + 40 bp
You are a swap dealer. Can you design a swap that makes both firms
better off? Assume that you can keep half of the profits, and split the
other half evenly between the two counterparties. In your answer show
(that is, either list or draw) all the inflows and outflows for every
counterparty.

Total potential gains to all the swap counterparties: (40+LIBOR - LIBOR)+(330350)=20 bp

Note that any time you set up a swap there is more than one way to do it
in a way that generates a specific distribution of profits to all the
counterparties. The solution here lists one of the possible examples. If you
set it up in a different way, but the results are consistent with the
conditions of the questions, you will get full credit.
The critical condition is that E&P borrows in LIBOR and OTC in fixed, since
only then you can generate profits (40bp 20 bp) as opposed to when E&P
borrows fixed and OTC-variable (20bp 40 bp).

Example of a swap:
Net inflows for each party:
Company E&P: (LIBOR+5) - (LIBOR)-330= -325 (this is the net (fixed) payment of
the firm in the swap deal)
Company OTC: 350-350-(LIBOR+35) = - (LIBOR+35) (this is the net variable
payment of the firm in the swap deal)
Swap dealer: 330-350+(LIBOR+35)-(LIBOR+5)=10 (this is the net gain half of the
total profit of 20 bp)
Net gains for each party:
As a result of the swap, Company A can now borrow at 325 fixed rate (as opposed to
330 it can get from a bank directly). Therefore its net gain is: 330 -325 = 5 (quarter
of the total profits)
As a result of the swap, Company B can now borrow at LIBOR+35 variable rate (as
opposed to LIBOR+40 it can get from a bank directly). Therefore its net gain is:
(LIBOR+40) (LIBOR+ 35) = 5 (quarter of the profits)
Note: the gains to all the parties have to sum up to the total potential gains:
5 +5 + 10 = 20

Formulae sheet:

Cash Flow From Assets (CFFA) = Cash Flow to Bondholders + Cash Flow
to Shareholders
Cash Flow From Assets = Operating Cash Flow Net Capital Spending
Changes in NWC
Operating Cash Flow = EBIT + depreciation taxes
Net Capital Spending = ending net fixed assets beginning net fixed
assets + depreciation
Changes in NWC = ending NWC beginning NWC
CF to Bondholders = interest paid net new borrowing
CF to Shareholders = dividends paid net new equity raised

Current Ratio = CA / CL
Quick Ratio = (CA Inventory) / CL
Cash Ratio = Cash / CL
Total Debt Ratio = (TA TE) / TA
Long Term Debt Ratio = LT Debt/ TA
Debt/Equity (D/E)= TD / TE
Equity Multiplier (EM) = TA / TE = 1 + D/E
Times Interest Earned = EBIT / Interest
Cash Coverage = (EBIT + Depreciation) / Interest
Inventory Turnover = Cost of Goods Sold / Inventory
Days Sales in Inventory = 365 / Inventory Turnover
Receivables Turnover = Sales / Accounts Receivable
Days Sales in Receivables = 365 / Receivables Turnover
NWC Turnover = Sales / NWC
Fixed Asset Turnover = Sales / Net Fixed Assets
Total Asset Turnover (TAT, or S/A)= Sales / Total Assets
Capital intensity ratio = Total Assets/ Sales
(Net) Profit Margin (PM, or p)= Net Income / Sales
Gross Profit Margin = (Revenues-COGS)/ Sales
Operating Profit Margin = Operating Income (EBIT)/ Sales
Return on Assets (ROA) = Net Income / Total Assets
Return on Equity (ROE) = Net Income / Total Equity
EPS = Net Income / Shares Outstanding
PE Ratio = Price per share / Earnings per share
Du Pont Identity: ROE = PM * TAT * EM

Internal Growth Rate

Sustainabl e Growth Rate

FVt PV (1 r )
g

PV

ROA R
1 - ROA R

ROE R
1 - ROE R

FVt
(1 r ) t

ROE R
p( S / A)(1 D / E ) R

1 - ROE R 1 - p( S / A)(1 D / E ) R

C
1

P(bond )

1
YTM
1 YTM
CF
PV
rg

1 g

1
1 r

PV FV0

FaceValue

1 reffective 1 stated
m

1 YTM T

C
PV (annuity)
r

1
1 r

T
FVt
FV1
FV2

...

2
t
1 r 1 r
t 0 1 r

PV ( perpetuity) C

rg

1 reffective e r ( stated)
T
1
1
PVIFA 1

r
1 r
PV C * PVIFA(r , T )

(1 + R) = (1 + r)(1 + h)

Statistical properties of random variables:

n

E ( X ) p1 x1 p2 x2 ... pn xn pi xi
i 1

( X ) Var ( X )
n

Var ( X ) p1 x1 E ( X ) ... pn xn E ( X ) pi xi E ( X )
2

i 1

Cov( X , Y ) p1 x1 E ( X ) y1 E (Y ) ... pn xn E ( X ) yn E (Y )
n

pi xi E ( X ) yi E (Y )
i 1

 ( X ,Y )

Cov( X , Y )
( X ) (Y )

Portfolio performance and cost of capital:

m

E ( RP ) w j E ( R j )
j 1

2
portfolio
w12 12 w22 22 2w1 w2 cov( R1 , R2 )

2
portfolio
w12 12 w22 22 2 w1 w2 1 2 ( R1 , R2 )

Cov( Ri , RM )

( RM )
2

i ,M

( Ri )
( RM )

E ( Ri ) RF i ( E ( RM ) RF )

portfolio wi i
i 1

WACC = wERE + wDRD(1-TC)