Corporate Finance - Revision

Multiple Choice Questions
Question 1

The benefits from diversification are maximised when two assets are:

A. perfect positively correlated B. perfectly negatively correlated C. uncorrelated D. either A or C

Question 2

The characteristics of two perfectly positively correlated assets are as follows: Asset A has a standard deviation of 20% while asset B has a standard deviation of 30%. The standard deviation of a portfolio consisting of an equal weighting of Asset A and Asset B is:

A. 50% B. 25% C. 75% D. 20%

Question 3

The standard deviations of two assets are 10 and 20 percent respectively. If an equally weighted portfolio produced a portfolio with a standard deviation of 14%, we can deduce regarding the two assets are:

A. negatively correlated B. perfectly positively correlated C. uncorrelated D. less than perfectly positively correlated

Question 4

A risk-averse investor owning shares in White Corporation decides to add the shares of either Black Corporation or Green Corporation to her portfolio. All three stocks offer the same expected return and total risk. The covariance of returns between White shares and Black shares is –0.05 and White shares and Green shares is +0.05. Portfolio risk is expected to:

A. Decline more by buying Black Corporation B. Decline more by buying Green Corporation C. Increase by buying either Black or Green Corporation D. Decline or increase, depending on other factors

Question 5

Which of the following portfolios cannot lie on the efficient frontier?

Portfolio Exp. Ret. Std. Dev. A. W 9% 21% B. X 5% 7% C. Y 15% 36% D. Z 12% 15%

Question 6

If the expected return for Jewel Ltd is 14% and the standard deviation is 4%, which of the following statements is true?

A. we can be confident that 95% of the time, the actual return for Jewel Ltd will lie in the range of 10% to 18% B. we can be confident that 95% of the time, the actual return for Jewel Ltd will lie in the range of 6% to 22% C. we can be confident that 68% of the time, the actual return for Jewel Ltd will lie in the range of -4% to +4% D. we can be confident that 68% of the time, the actual return for Jewel Ltd will lie in the range of 6% to 22%

Question 7

Beta can be described as a measure of:

A. The sensitivity of a share’s return to the return on the market B. The share price sensitivity to changes in interest rates C. The combination of business risk, liquidity risk, and purchasing power risk inherent in a share D. The return earned on a share relative to its risk

Question 8

What is the beta of a risk-free asset?

A. depends upon the risk of the market B. unity C. zero D. depends upon the size of the risk-free rate

Question 9

If the capital market is in equilibrium then for an asset:

A. it's expected return will be equal to the risk-free rate B. it's expected return will equal it's required rate of return C. it's expect return will be equal to the market return D. none of the above

Question 10

Both Portfolio X and Portfolio Y are well diversified. The risk-free rate is 8%, and the return for the market is 16%. The following information is available:

|Portfolio |Analysts forecast return |Beta |
|X |16% |1.00 |
|Y |12% |0.25 |

In this situation, which of the following about Portfolio X and Portfolio Y is true?

Portfolio X Portfolio Y A. Overvalued Properly valued B. Properly valued Undervalued C. Undervalued Properly valued D. Properly valued Overvalued

Question 11

The slope of the capital market line is:

A. the expected return divided by beta B. beta C. the market risk premium divided by the market standard deviation D. the market risk premium

Question 12

Which of the following statements is most correct?

A. Portfolio diversification reduces the variability of the returns of the individual stocks in the portfolio. B. If an investor buys enough stocks diversification will eliminate all of the non-market (or company-specific) risk. Indeed, if the portfolio contained all publicly traded stocks, it would be riskless. C. The required return on a firm's ordinary shares is determined by its systematic risk plus its non-systematic risk. D. A security's beta measures its non-diversifiable (systematic, or market) risk relative to that of an average stock.

Question 13

The weights used to compute the weighted-average required rate of return (WACC) should be obtained using:

A. the book value of a similar risk company B. the market value of debt and equity C. the book values of debt and equity D. the CAPM

Question 14

For a typical firm with a given capital structure, which of the following is correct? (note: all rates are after taxes).

A. re > WACC > rd B. re > rd > WACC C. WACC > re > rd D. rd > re > WACC

Question 15

The increase in risk associated with the leverage of a firm is called:

A. systematic risk B. business risk C. financial risk D. none of the above

Question 16

Modigliani and Miller (1958) proposed that in a perfect capital market:

A. the firm's weighted average cost of capital does increases or decreases as the firm's capital structure changes B. the required rate of return on equity of a levered firm is lower than the required rate of return on equity of an unlevered firm C. the value of a levered firm is lower than that of an unlevered firm D. none of the above

Question 17

Private equity investments typically do not have: A. A lower level of risk than most other investments B. A similar risk to most other investments C. All of the above D. None of the above

Question 18

If an investor purchases shares cum-rights, it means that: A. The investor will not participate in the rights issue B. The investor will participate in the rights issue C. The investor will participate in the rights issue without having to pay the subscription price D. The investor cannot sell the right separately

Question 19

Which lease is essentially a rental agreement? A. Finance lease B. Cross-border lease C. Operating lease D. Leveraged lease

Question 20

Which lease can be best defined as a finance lease where the lessor borrows most of the funds to acquire the asset? A. Finance lease B. Operating lease C. Cross-border lease D. None of the above

Short Answer Questions – Section B

Question. B1

You have just purchased 10 newly issued $100 five year ABC Company Ltd debentures at par. These debentures pay $6 (per debenture) in interest semi-annually. You are also negotiating the purchase of 10 $100 debentures issued by the DEF Company Ltd 4 years ago that return $3 per debenture in semi-annual interest payments and have six years remaining to maturity.
What is the maximum price you should offer for the DEF Company Ltd debentures, assuming the DEF Company Ltd is in the same risk class as the ABC Company Ltd?

DEF Debentures
Face value = $100,
Coupon PMT = $3, n = 6 years x 2 coupon payments per year = 12, r = 6% per half-year (same as coupon rate/yield on ABC Company Ltd debentures as they are in the same risk class).
Use bondprice formula to find the current price of the DEF Company Ltd debentures:
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Question. B2

At t = 0 the one-period rate of interest is 6%, the two year rate is 8% per annum, and the three-year rate is 10% per annum. What is the expected two-period interest rate at t = 1?

0 1 2 3

6% ?

8% p.a. 10% p.a.

(1+r)3 = (1+r)2 (1+r)1
(1+0.10)3 = (1+r)2 (1+0.06)1
1.331 = (1+r)2 1.06
1.331/1.06 = (1+r)2
1.2557 = (1+r)2
(1.2557)1 = (1+r)2
(1.2557)1/2 = (1+r)2/2
1.1206 = 1+r
1.1206 – 1 = 1-1+r
0.1206 = r r = 12.06%

Question. B3

You have been supplied with the following information: Asset Expected Return p.a. (%) Standard Deviation (%) BHZ Ltd 9 8 ANB Ltd 13 48

You are also told that the correlation coefficient between the returns of the two firms is 0.8. You wish to diversify your portfolio by investing 30 per cent in BHZ shares and 70 per cent in ANB shares.

a) What will be the expected return of the portfolio? [pic]

where Wi = the weighting of the asset in the portfolio, Ri = the return on the asset in the portfolio.

Therefore:

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b) What will be the standard deviation of the returns of the portfolio? [pic] (note – ρA,B = correlation coefficient) Therefore: [pic] [pic] [pic] [pic] [pic]

Question. B4

The following information has been obtained:
WACC = 11.40% p.a.
Before-tax cost of equity capital = 15% p.a.
Market value of the firm = $100 million
Market value of debt = $40 million
Corporate tax rate = 40%
Required: calculate the before-tax cost of debt.
WACC formula = [pic]
Therefore:
[pic]
0.1140 = 0.15(0.60) + rd(0.40)(0.60)
0.1140 = 0.09 + rd(0.24)
0.1140 – 0.09 = 0.09 – 0.09 + 0.24rd
0.024 = 0.24rd
0.024/0.24 = rd = 0.10 = 10% = before-tax cost of debt.

Longer Style Questions – Section C

Question C1

Adams Corp. has developed the following forecasts for expected returns, variances and correlation coefficients for 2 securities, the market index and 90-day Treasury Notes. Adams Corp intends to use those forecasts as the basis for investment decisions for the next year.

| |Expected Return |Standard Deviation |Correlation Matrix |
|Security |(% per annum) |(% per annum) |A |B |M |F |
|A | 16 | 6 | 1 | | | |
|B | 14 | 5 | 0.3 | 1 | | |
|Market Index (M) | 12.0 | 4 | 0.8 |0.6 | 1 | |
|90-day Treasury Notes (F) | 5.0 | 0 |0.3 | 0.2 | 0.1 | 1 |

Required:

(a) Calculate the expected return and standard deviation of returns for a portfolio (P) comprised of a 70% investment in Security A and 30% in Security B.

b) What is the beta for Security A, Security B and the portfolio?

c) Are the expected return forecasts provided by Adams Corp consistent with a CAPM equilibrium for securities A, B and the portfolio (P) from part (a). .

(a)

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(b)

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(c)

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Therefore, the actual return in the market for A (16%) is higher than the required return for A (13.4%), meaning the actual return is too high, so the price of Asset A must be too low, i.e. Asset A is underpriced/undervalued.

[pic]

Therefore, the actual return in the market for B (14%) is higher than the required return for B (10.25%), meaning the actual return is too high, so the price of Asset B must be too low, i.e. Asset A is underpriced/undervalued

[pic]

Therefore, the actual return in the market for the Portfolio (15.4%) is higher than the required return for the Portfolio (12.46%), meaning the actual return is too high, so the price of the Portfolio must be too low, i.e. the Portfolio is underpriced/undervalued.

Question. C2

Appsony Ltd Balance Sheet
$ Million
Issued Capital 20,000,000 ordinary shares of 50 cents each 10 2,000,000 6% cumulative preference shares of 50 cents each 1

Non Current Liabilities Corporate Bonds 10

Current Liabilities & Provisions Trade Creditors 10 Bank Overdraft 5
Notes to Question

1. 10,000 $1000 bonds are due in 5 years. The coupon rate of 7% is paid annually. 2. This is the standard level of overdraft maintained by the company. Current overdraft rates are 10% per annum. 3. The Beta risk of Appsony Ltd shares is 1.3. 4. The expected return on the market for equities is 12% per annum. 5. The risk free rate is 6% per annum. 6. The current market interest rate for similar risk bonds is 8% per annum. 7. The market value of an ordinary share is $4. 8. The current market value of a preference share is 30 cents. 9. Assume a corporate tax rate of 30 percent

Required: (a) Calculate the market value of Appsony Ltd. (Round to $millions with two decimal points.)

b) Calculate the weighted average cost of capital for Appsony Ltd.

a) market value of Appsony = debt + equity

i. Equity: ordinary shares = 20 million shares x $4 per share = $80 million preference shares = 2 million shares x $0.30 = $600,000 ii. Debt: bank overdraft = $5 million corporate bonds: use bondpricing formula [pic] face value = $1,000, coupon rate = 7% p.a., coupon PMT = 0.07 x $1,000 = $70, r = 8% p.a. (current market yield for similar risk bonds), n = 5 years

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Therefore, the total market value of the bonds is: $960.69 x 10,000 bonds = $9,600,690.00 [pic]

(b) before-tax cost of equity:

ordinary shares – CAPM = Rf + (Rm-Rf)βi = 0.06 + (0.12 – 0.06)1.3 = 0.138 = 13.8% Preference shares –

[pic] note: [pic]= dividend yield D = 6% of par value of $0.50 = $0.03

(c) after-tax cost of debt = rd(1-t), tax rate = 30%

corporate bonds = 0.08(1 – 0.30) = 0.08(0.70) =0.056

overdraft = 0.10(1 – 0.30) = 0.10(0.70) = 0.07

|Capital Item |Market Value |Weight |Before-Tax Cost |After-Tax Cost |Weighted Cost |
|Ordinary shares |$80,000,000 |0.8403 |0.138 |0.138 |0.1159 |
|Preferance shares |$600,000 |0.006302 |0.10 |0.10 |0.0006302 |
|Corporate bonds |$9,600,690 |0.1008 |0.08 |0.056 |0.005644 |
|Overdraft |$5,000,000 |0.05252 |0.10 |0.07 |0.003676 |
| |$95,200,690 |1.00 | |WACC = |0.1258 |
| | | | | |(12.58%) |

Question. C3 Your company is evaluating an irrigation system. The WT99 costs $60,000 has a 4 year life and will generate $27,500 in additional cash revenue per year.
The WT99 is depreciated by an amount of $15,000 per year. Because of the demand for the WT99, it is expected that it will have a salvage value of $14,000 at the end of its economic life.
The corporate tax rate is 30% and the company’s cost of capital is 12% p.a.
Required: Should the company go ahead with the WT99

Notes:

purchase price = $60,000

n = 4 years

incremental revenue p.a. = $27,500

depreciation p.a. = $15,000

book value at end = $0

salvage value = $14,000

book-gain on sale = $14,000

tax rate = 30%

r = 12% p.a. P & L Statement
|Item |Yr 0 |Yrs 1 – 3 |Yr 4 |
| |$ |$ |$ |
|incremental revenue | |27,500 |27,500 |
|depreciation | |(15,000) |(15,000) |
|book gain on sale | | |14,000 |
|profit | |12,500 |26,500 |
|tax | |(3,750) |(7,950) |

Cash-Flow Statement
|Item |Yr 0 |Yrs 1 – 3 |Yr 4 |
| |$ |$ |$ |
|tax | |(3,750) |(7,950) |
|purchase |(60,000) | | |
|incremental revenue | |27,500 |27,500 |
|salvage value | | |14,000 |
|net cash-flow |(60,000) |23,750 |33,550 |

Net Present Value
|Year |Cash-Flow |PVIF |Present-Value |
| |$ | |$ |
|0 |(60,000) |n/a |(60,000) |
|1 – 3 |23,750 |[pic] |57,042.75 |
|4 |33,550 |[pic] |21,321.02 |
| | | |NPV =18,363.77 |

Therefore, since NPV is positive, should proceed with the project.