The mix of debt and equity maintained by a firm

Introduction To Finance

- End of Study Period Examinations - Study Period 2, 2020
Campus: Singapore
Unit: INFP2000 - Introduction to Finance Principles
Duration: 72 hours
Total Marks: 50 Weighting: 50 %
Aids to be supplied by the College:

None

Aids to be supplied by the student:

1. Non-programmable calculator.

IMPORTANT INFORMATION Mobile phones or any other devices capable of communicating information are prohibited during examinations. Electronic Organisers / PDAs (with the exception of calculators) or any other similar device capable of storing text or restricted information are prohibited during examinations. Calculators – only calculators approved specifically by the College may be used during examinations. Any breaches of this policy will be considered cheating and appropriate action will be taken as per College policy.

Question 1

/10

Question 2

/5

Question 3

/5

Question 4

/10

Question 5

/10

Question 6

/10

Total Marks

/50%

Question One (10 marks)

For each of the following MCQs, record the correct answer on the line below each question.

1. Which of the following statements is most correct?

A. An advantage to incorporation is that it allows for less regulation of the business.

B. An advantage of a corporation is that it is subject to double taxation.

C. Unlike a partnership, a disadvantage of a corporation is that has limited liability.

D. Corporations face more regulations when compared to partnerships.

ANSWER: ________

2. An agency problem can be alleviated by:

A. requiring all firms to be sole proprietorships.

B. compensating managers in such a way that acting in the best interest of shareholders is also in the best interest of managers.

C. asking managers to take on more risk than they are comfortable taking.

D. A and B.

ANSWER: ________

3. Assets are classified as:

A. intangible or non-current

B. current or non-current

C. cash or accounts receivable

D. direct or indirect

ANSWER: ________

4. Capital structure is:

A. the mix of debt and equity maintained by a firm

B. the mix of short-term debt and assets held by a firm

C. the mix of long-term debt and assets held by a firm

D. the mix of dividends and debt maintained by a firm ANSWER: ________

5. The process of planning and managing a firm's investment in non-current assets is known as:

A. working capital management

B. financing decision

C. capital budgeting

D. earnings decision

ANSWER: ________

6. An investment is said to be liquid if the investment:

A. has large day to day fluctuations in price.

B. has a large bid-ask spread.

C. can easily be converted into cash.

D. is traded on a stock exchange.

ANSWER: ________

7. The largest stock market in the world by volume is:

A. the London Stock Exchange.

B. NASDAQ.

C. the American Stock Exchange.

D. the New York Stock Exchange.

ANSWER: ________

8. Which of the following statements is FALSE?

A. On Nasdaq, stocks can and do have multiple market makers who compete with each other. Each market maker must post bid and ask prices in the Nasdaq network where they can be viewed by all participants.

B. Bid prices exceed ask prices.

C. Because customers always buy at the ask and sell at the bid, the bid-ask spread is a transaction cost investors have to pay in order to trade.

D. On the floor of the NYSE, prior to 2005 market makers (known on the NYSE as specialists) matched buyers and sellers.

ANSWER: ________

9. The standard deviation for a set of stock returns can be calculated as the:

A. positive square root of the average return

B. average squared difference between the actual and the average return

C. positive square root of the variance

D. variance squared

ANSWER: ________

10. The hypothesis that market prices reflect all available information is called efficiency in the:

A. semi-strong form

B. strong form

C. weak form

D. open form ANSWER: ________

11. The excess return required from an investment in a risky asset over a risk-free investment is called:

A. a return premium

B. a risk premium

C. an average return

D. only a return premium and a risk premium

ANSWER: ________

12. Which of the following is generally considered to represent the risk-free return?

A. common stocks

B. small stocks

C. long-term corporate bonds

D. treasury bills

ANSWER: ________

13. Assume that you buy some shares for $2.50 per share. At the end of the year, the price is $3.50 per share. During the year you got a dividend of $0.20 per share. What is the dividend yield?

A. 10.0%

B. 15.0%

C. 8.0%

D. 40.0%

ANSWER: ________

14. Assume that you buy some shares for $2.50 per share. At the end of the year, the price is $3.50 per share. During the year you got a dividend of $0.20 per share. What is the capital gains yield?

A. 250.0%

B. 100.0%

C. 40.0%

D. 8.0%

ANSWER: ________

15. You purchased 500 shares in A Limited on 1 January 2015 for $85 per share. Now, assume that the stock pays an annual dividend of $12 per share. On 31 December 2015, the market price is $91 per share. What is your total dollar return for the year?

A. $3 000

B. $6 000

C. $9 000

D. $45 500

ANSWER: ________

16. Taggart Transcontinental pays no dividends, but spent $4 billion on share repurchases last year. Taggart's equity cost of capital is 13% and the amount spent on repurchases is expected to grow by 5% per year. Taggart currently has 2 billion shares outstanding. Taggart's market capitalization is closest to:

A. $25 billion

B. $31 billion

C. $40 billion

D. $50 billion

ANSWER: ________

17. Defenestration Industries plans to pay a $4.00 dividend this year and you expect that the firm's earnings are on track to grow at 5% per year for the foreseeable future. Defenestration's equity cost of capital is 13%. Assuming that Defenestration's dividend payout rate and expected growth rate remain constant, and Defenestration does not issue or repurchase shares, then Defenestration's stock price is closest to:

A. $50.00

B. $32.30

C. $22.25

D. $30.75

ANSWER: ________

18. A firm's net investment is:

A. its capital expenditures in excess of depreciation.

B. its free cash flow net of increases in working capital.

C. its enterprise value in excess of debt owed.

D. the market value of equity plus debt.

ANSWER: ________

19. Which of the following statements is FALSE?

A. The most common valuation multiple is the price-earnings (P/E) ratio.

B. You should be willing to pay proportionally more for a stock with lower current earnings.

C. A firm's P/E ratio is equal to the share price divided by its earnings per share.

D. The intuition behind the use of the P/E ratio is that when you buy a stock, you are in sense buying the rights to the firm's future earnings and differences in the scale of the firms' earnings are likely to persist.

ANSWER: ________

20. Rearden Metals has a current stock price of $30 share, is expected to pay a dividend of $1.20 in one year, and its expected price right after paying that dividend is $33.Rearden's expected dividend yield is closest to:

A) 3.40%

B) 3.65%

C) 4.00%

D) 4.20%

ANSWER: ________

Question Two (5 marks)

For each of the following “True or False” questions, record the correct answer on the line below each question.

Q1. Working capital management includes making decisions about how much cash and inventory to keep on hand.

ANSWER: _______

Q2. A financial manager must be certain about future cash flows when making investment decisions.

ANSWER: _______

Q3. Management may be tempted to make decisions that benefit themselves rather than the shareholders they represent. Management compensation, however, can be structured to better align management interests with shareholder interests.

ANSWER: _______

Q4. It is impossible to have a negative interest rate, therefore it is impossible to have a negative real return on a bond.

ANSWER: _______

Q5. Over the long term, shares have a higher return than bonds. We should only ever hold a minimal amount of bonds in a portfolio.

ANSWER: _______

Q6. The discounted free cash flow model ignores interest income and expense but adjusts for cash and debt directly.

ANSWER: _______

Q7. We can interpret the enterprise value as the net cost of acquiring the firm's equity, taking its cash, and paying off all debts.

ANSWER: _______

Q8. In the method of comparables, the known values of a firm's cash flows are used to estimate the unknown cash flows of a similar firm.

ANSWER: _______

Q9. Shares' returns will tend to move together if they are affected similarly by economic events.

ANSWER: _______

Q10. Almost all of the correlations between shares are negative, illustrating the general tendency of shares to move together.

ANSWER: _______

Question Three (5 Marks)

a) Pandemic Solutions Company has just paid a cash dividend of 20 cents per share. Investors require a 16% return from investments such as this. If the dividend is expected to grow at a steady rate of 4% per year, what is the current value of the share? What will the share be worth in five years? Show working out.

(2.5 Marks)

b) Southern Livestock Corporation is considering an investment with a payback of five years and a cost of $12000. If the required return is 8%, what is the worst-case NPV? Explain. Show working out.

(2.5 Marks)

Question Four (10 Marks)

What are the main types of risk and to what extent can diversification reduce risks associated with stock portfolios?

Question Five (10 Marks)

Suppose we had the following investments:

Security

Amount Invested $

Expected Return %

Beta

Property

9600

6

0.84

Solvents

19200

8

1.05

Landholdings

14400

10

1.26

Chemicals

4800

14

1.68

Show working out.

a) What are the portfolio weights? (3 marks)

b) What is the expected return on the portfolio? (4 Marks)

c) What is the portfolio beta? (3 Marks)

Question Six (10 marks)

What is the Capital Asset Pricing Model (CAPM) and how does the security market line illustrate how this model works?