Exam

Question 1

The objective to be pursued by the management of a business corporation is to:

a) maximise the reported profits of the corporation
b) satisfy the needs of all stakeholders; incl earning a reasonable return on equity
c) add max value to the capital contributed by the lenders and shareholders
d) ensure wealth and security for themselves

Answer 1

c) add max value to the capital contributed by the lenders and shareholders

Question 2

Some of the agency costs of management include:

a) managers seeking perquisites such as corp jets and stock options
b) the tendency for managers to over-invest
c) the costs of auditing the financial reports of the corporation
d) only answers A&C above
e) All of the answers A,B & C

Answer 2

e) All of the answers A,B & C

Question 3

An insight to capital expenditure appraisal arising from option pricing thinking is:

a) the recognition ‘traditional’ NPV analysis involves spending now and passively watching events unfold in the future
b) waiting to make a decision can be valuable
c) the higher the uncertainty associated with events then the more valuable is flexibility in decision making
d) all of the above
e) none of the above

Answer 3

d) all of the above

Question 4

Which of the following measures of senior management performance would be most likely to reduce the principal-agent problem for shareholders of a listed company?

a) growth in the company’s market capitalisation
b) earnings per share growth
c) return on equity
d) the company’s holding period return relative to peer group companies
e) the dollar value of profits after tax

Answer 4

d) the company’s holding period return relative to peer group companies

Question 5

Company has developed new product. Considering building new plant to manufacture. What would affect NPV calcs?

a) Company offers retailers longer payment terms than usual to encourage sales
b) research conducted on new product can be fully written off against tax
c) company’s B/S has capacity for more debt and therefore entire project can be debt financed

Answer 5

a) Company offers retailers longer payment terms than usual to encourage sales

Question 6

What would be the best description of how high levels of debt may affect the value of a corporation due to the effect on agency costs:

a) There will be no effect on agency costs due to high debt levels
b) high debt levels will decrease all agency costs
c) high debt levels will tend to increase the agency costs of debt
d) both C & D could be correct

Answer 6

c) high debt levels will tend to increase the agency costs of debt

Question 7

Note for EAC calculations:

Answer 7

Use calculator - TVM; plug in PV; n and I%.

PV calculated by forecasting the cash flows

Question 8

Note for comparing flows in nominal vs real terms:

Answer 8

Can adjust the cash flows to cater for inflation, or adjust the discount factor. Ensure cash flow type is consistent with discount rate (ie real vs nominal)

Real rate = (1+nom interest %) / (1+ inflation) -1

Question 9

A company decreased the risk of its assets through a diversifying acquisition. Suppose no synergy or value was created by the acquisition. What happens to the value of debt and equity?

a) the value of equity will increase and the value of debt will decrease
b) the value of equity will decrease and the value of debt will increase
c) decreased risk will decrease the value of both debt & equity
d) decreased risk will increase the value of both debt & equity
e) The value of debt and the value of equity will both remain unchanged

Answer 9

b) the value of equity will decrease and the value of debt will increase

Question 10

Which of the following statements about capital structure are most correct

a) companies whose asset value may vary substantially have less debt than stable companies
b) companies with tax losses will tend to have less debt
c) A lower level of debt can be taken as a sign of good management
d) A,B and C are correct
e) only A&B are correct

Answer 10

e) only A&B are correct

Question 11

The APV method to value a project should be used when the

a) project’s level of debt is known over the life of the project
b) project’s target debt to value ratio is constant over the life of the project
c) project’s debt financing is unknown over the life of the project
d) both A&B
e) both B&C

Answer 11

a) project’s level of debt is known over the life of the project

Question 12

For a company with multiple lines of business the problem with using the firm’s overall beta in valuing all new investment proposals is that:

a) the firm would accept too may high risk projects
b) the firm would reject too many projects with low risk
c) the firm would accept too many projects with low risk
d) Both A&B could be correct
e) both A&C could be correct

Answer 12

d) Both A&B could be correct

Question 13

Company reports latest investment has earned return of 28%, calculated as IRR of cash flows to shareholders. Investment initially funded with 70% debt, but by time of exit (5 yrs) this declined to 35% in line with industry average. What issues are there?

a) all the usual probs with IRR, including the reinvestment assumption
b) given changing capital structure, there is no clear benchmark to measure the result
c) measure is not transparent so it’s difficult to assess contribution to value made by financing strategy
d) IRR is used correctly, because it is based on CFs to eq holders
e) A, B, and C are all correct

Answer 13

e) A, B, and C are all correct

Question 14

The M&M theory of dividend irrelevance does not provide an adequate description of the real world because

a) higher dividends will increase the market value of the company
b) divs are less risky than capital gains
c) M&M assume there are no changes to company’s investments
d) companies generally do not change div payouts in any case
e) markets are inefficient and do not value dividends correctly

Answer 14

c) M&M assume there are no changes to company’s investments

Question 15

A company is considering returning capital to shareholders. Which of the following considerations should they take into account?

a) the effect of different techniques of capital management on EPS
b) how the transaction can be made tax-efficient for shareholders
c) the need to build a war chest against future contingencies
d) the interest rate that could be earned on the cash
e) all of the above

Answer 15

b) how the transaction can be made tax-efficient for shareholders

Question 16

“A” merges with “B” by exchanging A shares for B shares. B is unrelated; cashflows not perfectly correlated. No synergies. B has no debt. A has $200m bonds. Which is correct:

a) WACC of A will fall due to diversification benefits
b) combines eq after the deal will have lower value than the total for the two companies before hand
c) A will have lower credit rating since it is less focused
d) A debt will have a higher yield due to diversification
e) none of the above

Answer 16

b) combines eq after the deal will have lower value than the total for the two companies before hand

Question 17

You are conducting an NPV analysis of your company’s first investment in a foreign country. Which of the following adjustments may be appropriate.

a) increasing the discount rate by a premium to reflect the fact that the company is unfamiliar with political and economic risks in the foreign country
b) a scenario analysis of cash flow forecasts to reflect possible economic and political risks
c) translating cash flow forecasts using the management’s best forecast of future exchange rates
d) A and C
e) B and C

Answer 17

b) a scenario analysis of cash flow forecasts to reflect possible economic and political risks

Question 18

If actual debt level is lower than target:

Answer 18

• move from actual to potential by borrowing funds and making a capital return to shareholders;
• or use debt to adjust towards target next time you have a funding requirement.
• if existing business has unused debt capacity; value can be created simply by borrowing and repurchasing some shares.
• be careful to separate actual funding from project’s debt capacity.

Question 19

List ways to distribute funds to shareholders

Answer 19

1. Special dividend
2. Pro rata return of capital
3. On market buy back
4. Off market Buyback (equal access vs selective)

Question 20

List 2 factors influencing the choice of means by which funds are distributed to shareholders

Answer 20

1. Personal tax effects

2. Ability to raise cash (eg for buy back, shareholder may not wish to sell)

Question 21

Issues with using IRR

Answer 21

1. Does not adjust for differences in operating risk and gearing between projects
2. in non level perpetuity projects the (equity) IRR may not stay constant because gearing will change
3. Issues with reinvestment rate - it is assumed to be the same across time.
4. Possibility for multiple IRRs

Question 22

Benefit of lease is that it frees up capital for other purposes, so you should value it using WACC. COMMENT.

Answer 22

1. WACC tells us whether the return on the project is sufficient to meet the return required by all stakeholders including debt and equity. If positive it exceeds the return.
2. Evaluation of lease proposal is a funding decision to determine whether leasing is more attractive than normal debt.
3. The discount rate needs to be consistent with the cash flows. The cash flows in the lease proposal represent debt servicing and therefore the discount rate needs to reflect the return required by the lessor (cost of the debt reflected in the cash flows).
4. We use after tax Rd to incorporate the benefit of the ITS.
5. If we used a WACC this wouldn’t be valid because WACC includes the return required by equity holders and the cash flows do not include cash flows available to equity holders. Therefore violates the consistency principle.
6. Lease company may be suggesting WACC because it would make the lease value look better. WACC > Rd(1-T),

Question 23

The APV method to value a project should be used when

a) project’s level of debt is known over the life of the project
b) project’s target debt to value ration is constant over the life of the project
c) project’s debt financing is unknown over the life of the project
d) both project’s level of debt is known over the life of the project and project’s target debt to value ratio is constant over the life of the project
e) both project’s target debt ot value ratio is constant over the life of the project and project’s debt financing is unknown over the life of the project

Answer 23

a) project’s level of debt is known over the life of the project

Question 24

When comparing levered vs unlevered capital structures, leverage works to increase EPS for high levels of EBIT because:

a) interest payments on the debt vary with EBIT levels
b) interest payments on the debt stay fixed, leaving less income to be distributed over less shares
c) interest payments on the debt stay fixed, leaving more income to be distributed over less shares
d) interest payments on the debt stay fixed, leaving less income to be distributed over more shares
e) interest payments on the debt stay fixed, leaving more income to be distributed over more shares

Answer 24

c) interest payments on the debt stay fixed, leaving more income to be distributed over less shares

Question 25

Covenants restricting the use of leasing and additional borrowings primarily protect:

a) the equity holders from added risk of default
b) debt holders from the added risk of dilution of their claims
c) the debt holders from the transfer of assets
d) the management from having to pay agency costs
e) none of these

Answer 25

b) debt holders from the added risk of dilution of their claims

Question 26

In calculating the NPV using the flow to equity approach the discount rate is the

a) all equity cost of capital
b) all equity cost of capital minus the weighted average cost of debt
c) weighted average cost of capital
d) all equity cost of capital plus the weighted average cost of debt
e) cost of equity for the levered firm

Answer 26

e) cost of equity for the levered firm

Question 27

The beta of a firm is more likely to be high under what two conditions:

a) high cyclical business activity and low operating leverage
b) high cyclical business activity and high op leverage
c) low cyclical business activity and low financial leverage
d) low cyclical business activity and low op leverage
e) none of these

Answer 27

b) high cyclical business activity and high op leverage

Question 28

Bad reasons for leasing

Answer 28

1. provide 100% financing
2. not considered a form of debt financing
3. leasing may increase EPS relative to buying

Question 29

In order to value a project which is not scale enhancing, you need to…

Answer 29

typically calculate the equity cost of capital using the risk adjusted beta of another firm in the industry before calculating the WACC

Question 30

What 3 factors are important to consider in determining the target debt to equity ratio?

Answer 30

Taxes
Asset types
Uncertainty of operating income

Question 31

If you want to review a project from a benefit-cost perspective, you should use the:

a) NPV
b) payback
c) IRR
d) Av accounting return
e) profitability index

Answer 31

e) profitability index

Question 32

Covenants restricting the use of leasing and additional borrowings primarily protect:

Answer 32

the debt holders from the added risk of dilution of their claims

Question 33

The possibility that more than one discount rate will make the NPV of an investment equal to zero is called the _______ problem

Answer 33

multiple rates of return

Question 34

The point where a project produces a rate of return equal to the required return is known as the…..

Answer 34

present value break-even point

Question 35

When making financial decisions related to assets, you should:

a) always consider market values.
b) place more emphasis on book values than on market values.
c) rely primarily on the value of assets as shown on the balance sheet.
d) place primary emphasis on historical costs.
e) only consider market values if they are less than book values.

Answer 35

a) always consider market values

Question 36

MM Proposition II is the proposition that:

a) supports the argument that the capital structure of a firm is irrelevant to the value of the firm.
b) the cost of equity depends on the return on debt, the debt-equity ratio and the tax rate.
c) a firm’s cost of equity capital is a positive linear function of the firm’s capital structure.
d) the cost of equity is equivalent to the required return on the total assets of a firm.
e) supports the argument that the size of the pie does not depend on how the pie is sliced.

Answer 36

c) a firm’s cost of equity capital is a positive linear function of the firm’s capital structure.

Question 37

The condition stating that the interest rate differential between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate is called:

a) the unbiased forward rates condition.
b) uncovered interest rate parity.
c) the international Fisher effect.
d) purchasing power parity.
e) interest rate parity.

Answer 37

e) interest rate parity.

Question 38

Which one of the following is most likely a variable cost?

a) Office rent
b) Property taxes
c) Property insurance
d) Direct labor costs
e) incorrect Management salaries

Answer 38

d) Direct labor costs

Question 39

If question says: “calculate the increase in value of the firm’s stock” use the ??? approach

Answer 39

Flow to Equity

Question 40

Articulate strategy for when target $ debt level exceeds initial outlay required:

Answer 40

1. Outlay is < target debt $ value calculated
2. We can borrow $xxx
3. Strategy is to borrow the target, fund the outlay and return the difference to shareholders.

Question 41

Discount rates:

1. If comparing D to E (eg fund with all equity; then consider a loan option): Use xxx
2. If comparing D to D; use xxx
3. If considering top up or displacement debt; capacity can be measured using the difference in AT CFs discounted by Pre Tax debt. Then the NPV is this capacity discounted by AT debt; less the difference using PT debt.

Answer 41

Discount rates:

1. If comparing D to E (eg fund with all equity; then consider a loan option): Use PRE TAX DEBT
2. If comparing D to D; use AT DEBT
3. If considering top up or displacement debt; capacity can be measured using the difference in AT CFs discounted by Pre Tax debt. Then the NPV is this capacity discounted by AT debt; less the difference using PT debt.