Business Finance Exam 2, Fall 2023 PDF

© Kelly D. Welch **Business Finance** 4164 Capitol Federal Hall \(785) 864-7614, kwelch\@ku.edu The University of Kansas School of Business **Exam 2, version 8, Fall 2023** Exam time: 1 hour, 15 minutes. Pace yourself. Check that you have 4 pages plus formula sheets. Read each question carefully...

© Kelly D. Welch **Business Finance** 4164 Capitol Federal Hall \(785) 864-7614, kwelch\@ku.edu The University of Kansas School of Business **Exam 2, version 8, Fall 2023** Exam time: 1 hour, 15 minutes. Pace yourself. Check that you have 4 pages plus formula sheets. Read each question carefully, and answer in the space provided, indicating extra work on back. 100 total points, allocated across: Problems as indicated. Multiple choice 4 points each. **University of Kansas School of Business Honor Code** If you leave this pledge unsigned, your exam will not be graded until you contact me to discuss why. "On my honor, I have neither given nor received any unauthorized aid on this exam. Nor am I aware of anyone giving or receiving any unauthorized aid on this exam." \_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_ Seat \# Name KU ID \# Signature Date **Your multiple choice answers will only count if they are written neatly in the following boxes.** **1** **2** **3** **4** **5** **6** **7** **8** **9** **10** **11** ------- ------- ------- ------- ------- ------- ------- ------- ------- -------- -------- 1\. Which of the following statements is TRUE? A. By investing in varied and numerous assets, an investor can virtually eliminate all asset-specific risks in her portfolio, both easily and cheaply. B. It is possible, but not very easy, for an investor to control market-wide risks in his portfolio and increases in these market-wide risks are costly because they reduce expected returns. C. The most important characteristic in determining the expected return of a well-diversified portfolio is the total variance risks of the individual assets in the portfolio. D. When a portfolio has a positive investment in every one of its assets, its standard deviation cannot be less than that on every asset in the portfolio 2\. Which of the following statements is FALSE? A. The cost to a firm for capital funding equals the expected return to the providers of those funds B. WACC is affected by market conditions including interest rates, tax rates, and the market risk premium C. A firm's cost of capital depends primarily on the source of the funds, not the use D. A firm\'s WACC reflects the average risk of the existing projects undertaken by the firm 3\. Which of the following statements is ***FALSE***? A. Over the long run, investments in small-company stocks have had the largest return but also the most risk, when compared with large-company stocks, bonds, and T-Bills. B. The average return is always less than the geometric return. C. Investors who hold bonds instead of stocks over long horizons can be rational and relatively averse to risk. D. Unlike the capital gains yield, the dividend yield can never be negative. 4\. If any, which of the following does NOT have the potential to increase the net present value of a proposed investment? A. The ability to immediately shut down a project should the project become unprofitable B. The ability to wait until the economy improves before making the investment C. The option to increase production beyond that initially projected D. All of the above have the potential to increase the NPV of a proposed investment 5\. Which of the following statements is ***FALSE***? A. The internal rate of return is defined as the discount rate which results in a zero net present value for the project. B. The primary advantage to payback analysis is that it biases companies to invest in long-term projects that require large current expenditures on research and development. C. The average accounting return ignores cash flows is most similar to computing the return on assets (ROA). D. The profitability index reflects the value created per dollar invested. 6\. Which of the following statements is TRUE? A. The Gordon Growth Model assumes constant dividend growth but implies that stock prices grow at a different rate. B. A stock's price is the present value of its future cash flows, namely, its expected capital gains and dividends. C. Brokers buy and sell securities from their own inventory, while dealers bring buyers and sellers together to complete transactions. D. Holders of common stock have greater voting rights in corporate decisions than holders of preferred stock, but they have less voting rights than creditors of the corporation 7\. Which of the following should not be included in the analysis of a proposed investment? A. The current market value of an existing building to be used in the project. B. The amount paid 4 years ago for an existing building to be used in the project. C. The expected after-tax salvage value at the end of a project of an existing building to be used in the project. D. The net working capital balance remaining at the end of the project. 8\. Fill in the blanks: Standard deviation measures \_\_\_\_\_\_ risk, while beta measures \_\_\_\_\_\_ risk. A. Asset-specific; market-wide B. Market-wide; total C. Total; market-wide D. Total; asset-specific 9\. Which one of the following statements is TRUE? A. The risk-free rate of return has a risk premium of 1.0. B. The reward for bearing risk is called the standard deviation. C. Risks and expected return are inversely related. D. The higher the expected rate of return, the wider the distribution of returns 10\. Newly issued securities are sold to investors in which one of the following markets? A. Proxy B. Inside C. Secondary D. Primary 11\. A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions. By doing so, the firm: A. Automatically gives preferential treatment in the allocation of funds to its riskiest division B. Encourages the division managers to only recommend their most conservative projects C. Maintains the current risk level and capital structure of the firm D. Automatically maximizes the total value created for its shareholders Q1. (12 points) Apple is considering the following mutually exclusive investments: Year 0 1 2 3 ---------- ------ ----- ----- ----- MacBooks -900 300 400 500 iPads -200 100 200 400 Assuming an 9% discount rate, calculate the following for each project and circle which number is better between the two. a. Net Present Value (NPV) b. Payback c. Profitability Index d. Based on your following answers, which project(s), if any, would you choose? Q2. (15 points) Estimate the existing weighted average cost of capital using this information for a utility company with a 35% marginal tax rate and a 30% average tax rate: - Existing bonds with \$500m face outstanding mature in 15 years, with a 5% coupon rate paid semiannually, rated A1 by Moody's, with a current quoted yield of 6% per year, and trading for 90% of face value. - 1m preferred shares each pay a \$7.00 annual dividend and has a current market price of \$102. - 5m common shares with a current market price of \$80. This company's dividend over the past year was \$4.40, and it is expected to grow at 4% per year over the long run. **\ ** Q3. (9 Points) Assume these are *your* forecasts for the returns on 2 stocks: Expected Return Volatility Market Beta --------- ----------------- ------------ ------------- Stock A 8.0% 50% 0.9 Stock B 12.0% 40% 1.2 Your portfolio is unwisely invested entirely in these stocks, with \$6m in stock A and \$24m in stock B. a\) What is the expected return on your portfolio? b\) Suppose that the risk-free rate is 2%, the market risk premium is 6%, and that everyone else in the market believes CAPM's model for expected returns. Based on your forecasts for Stock A above, would you want to own more of Stock A or not? Briefly explain why. Q4. (12 points) A stock has had returns of 35%, --52%, and 20% over the past three years. a\) What was its historical arithmetic average return? b\) What the geometric average return? c\) How much would \$1 invested in this stock three years ago be worth today (that is, calculate the total return index over these three years)? d\) What was the historical volatility for this stock? Show your calculation. Q5. (8 Points) Currently Perla sells 200,000 Contractor grade windows per year at \$200 each, and 100,000 Architect grade windows per year at \$600 each. The company plans to introduce a Builder grade window and expects to sell 100,000 of these windows per year at \$700 each. Because these Builder grade windows will be more easily matched with the Contractor grade windows, Perla expects to be able to sell an additional 20,000 Contractor grade windows. However, Perla also expects that the Builder grade windows will compete with and reduce its sales of Architect grade windows by 40,000 units. What is the relevant amount to use as the annual sales figure when evaluating this project? **Exam 1 Formula Sheet Chapters 1-6:** These WILL be provided on exam 1 and the final exam Operating Cash Flow = EBIT -- Taxes + Depreciation CapEx = ΔNFA + Depreciation NWC = CA -- CL Average effective tax rate = tax expense / taxable income 'Net Debt' = Debt -- Cash Book Equity = A -- L Market Cap = n \* P EPS = Net Income / n PE = P / EPS Book Value per Share = Book Equity / n Market-to-Book = P / Book Value per Share Price to Sales = Market Cap / Sales ROE = NI / Book Equity = Market-to-Book ÷ PE ROA = NI / Assets Profit Margin = NI / Sales Asset Turnover = Sales / Assets Capital Intensity = Assets / Sales Interest Coverage 'TIE' = EBIT / Interest Total Debt Ratio = (Assets -- BookEquity) / Assets Leverage = Liabilities / BookEquity Equity Multiplier = A/E = 1 + L/E Current Ratio = CA/CL Retention ratio = b = Addition to Retained Earnings / NI Internal Growth Rate Sustainable Growth Rate Implied Retention Ratio *b* = *g* / \[ROE \* (1 + *g*)\] PV = V~0~ = CF~T~ / (1+r)^T^ ­ FV = PV \* (1+r)^T^ r = (FV/PV)^1/T^ -- 1 T = ln(FV/PV) / ln(1+r) Fisher: Nominal Rate ≈ Real Rate + Expected Inflation Rate Exact: (1 + Nominal) = (1 + Real) \* (1 + Expected Inflation) **Final Exam Formula Sheet Chapters 16-18 &24:** These WILL be provided on the final exam Cash & Mkt Secs = -- Accts Receivable -- Inventory + Accts Payable + ST Debt Inventory TurnOver = COGS / Avg Inv Inventory period = 365 / Inv TO Accounts Receivable TurnOver = Sales / Avg AR Receivables period = 365 / AR TO Accounts Payable TurnOver = COGS / Avg AP Payables period = 365 / AP TO Operating Cycle = Inventory period + Receivables period Cash Cycle = Operating Cycle -- Accounts Payable period Q/2 = Average inventory T/Q = Orders per year Carrying Costs = C (Q/2) Restocking Costs = F (T/Q) Total Costs = C (Q/2) + F (T/Q) Float = available balance at bank -- book balance For credit terms 2/10 net 45, EAR = \[1 +.02/(1--.02)\]^365/(45--10)^ -- 1 Interest Rate Parity Call Payoff at expiration T = max\[S~T~--K,0\] Current Intrinsic value of call = max\[S~0~--K,0\] **\ Exam 2 Formula Sheet Chapters 7-12:** These WILL be provided on exam 2 and the final exam Operating Cash Flow = EBIT + Depr -- Taxes = (Sales -- Costs)(1 -- T) + Depr\*T CapEx = ΔNFA + Depr After-tax Salvage = SalePrice -- T\*(SalePrice -- Book) r~t+1~ = (D~t+1~ + P~t+1~ -- P~t~) / P~t~ Dividend Yield = D~t+1~ / P~t~ Capital Gains Yield = (P~t+1~ -- P~t~) / P~t~ Geometric Return = \[(1+r~1~)(1+r~2~)∙∙∙(1+r~T~)\]^1/T^ -- 1 Average Return = (r~1~+r~2~+∙∙∙+r~T~) / T Variance = sum of squared deviations from average / (T--1) Standard Deviation = square root of Variance = Volatility Geometric average ≈ arithmetic average -- ½ volatility^2^ Historical Risk Premium = Average Return -- Average T-Bill Return E\[r\] = p~1~ r~1~ + p~2~ r~2~ +...+ p~n~ r~n~ Variance σ^2^ = p~1~(r~1~ -- E\[r~1~\])^2^ + p~2~(r~2~ -- E\[r~2~\])^2^ +...+ p~n~(r~n~ -- E\[r~n~\])^2^ Standard Deviation or Volatility σ = √Variance r~P~ = w~A~ r~A~ + w~B~ r~B~ +...+ w~Z~ r~Z~ E\[r~P~\] = w~A~ E\[r~A~\] + w~B~ E\[r~B~\] +...+ w~Z~ E\[r~Z~\] σ~P~ **\