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7211AFE Corporate Finance – Practice Questions for Final Exam
Question 4 

EBIT for Sharks Ltd is $163.934 and the cost of capital (Ru) is 20%. Taxes are 39%. What is 

the value of the firm? 

Answer: $500 

Question 5 

The expected return on HiLo stock is 13.69 % while the expected return on the market is 

11.5%. The beta of HiLo is 1.3. What is the riskfree rate of return? 

Answer: 
4.2% 
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Question 8 

What is the market return if the expected return on asset A is 15% and the 10year 

government bond rate is 6%. Beta for asset A is .9. 

Answer: 16% 

Question 9 

What is the portfolio variance if 30 percent is invested in stock S and 70 percent is invested in 

stock T? 
State of 
Probability of State of Economy 
Returns if State Occurs 

Economy 
Stock S 
Stock T 

Boom 
40% 
12% 
20% 

Normal 
60% 
6% 
4% 

Answer: 0.004056 

We now have the payoffs in each state: 

Use equation (28) 

E(R _{P} ) = pr(boom) ×payoff(boom) + pr(normal) ×payoff(normal) 

= 0.4×0.176+0.6×0.046 = 0.098 

Now use equation (29) 

Var(R _{P} ) = 0.4 × (0.1760.098) ^{2} + 0.6 × (0.0460.098) ^{2} = 0.004056 
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Stock Expected Return Beta 

A .68 
8.2% 

B 1.42 
13.9% 

C 1.23 
11.8% 

D 1.31 
12.6% 

E .94 
9.7% 

Answer: 
B 

The market risk premium is E(R _{m} )R _{f} = 0.08, R _{f} = 0.025 

E(R _{A} ) = R _{f} + b (E(R _{m} )R _{f} ) = 0.025 + 0.68×0.08 = 0.0794 

E(R _{B} ) = 0.1386 E(R _{C} ) = 0.1234 E(R _{D} ) = 0.1298 E(R _{E} ) = 0.1002 

Stock B is correctly priced (assuming the CAPM holds). 
Question 15 

Using the following information, calculate the portfolio beta and expected return: 

Event Wealth invested 
Expected return 
Beta 

A $1,000 
8% 
0.80 

B $2,000 
12% 
0.95 

C $3,000 
15% 
1.10 

D $4,000 
18% 
1.40 

Answer: 1.16, 14.9% 
Question 19 

The Lingo Co. has a debtequity ratio of .60. The firm is analyzing a new project which 

requires an initial cash outlay of $450,000 for new equipment. The flotation cost for new 

equity is 10 percent 
and for debt 5 percent. What is the true cost of the project? 

Answer: 
$489,796 
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Question 20 

You own 300 shares of Abco, Inc. stock. The company has stated that it plans on issuing a 

dividend of $.60 a share at the end of this year and then issuing a final liquidating dividend of $2.20 a share at the end of next year. Your required rate of return is 9 percent. Ignoring taxes, 

what is the value of one share of this stock today? 

Answer: $2.40 
Question 21 Astra limited company sells a slice of pizza for $1.20. The variable cost is 80 cents per slice and the marketing operation has fixed costs of $360 000 per year. Depreciation is $60 000 per year. What is the accounting breakeven? Answer: 1 050 000 slices of pizza
Question 22 

Rosie’s Grill has a beta of 1.2, a stock price of $26 and an expected annual dividend of $1.30. 

The dividend growth rate is 4 %. The market has a 10 % rate of return and a risk premium of 

6 %. What is the average expected cost of equity for Rosie’s Grill? 

Answer: 
10.10 % 
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Question 31 You are considering a new project. The project has depreciation of $720, fixed costs of $6,000, and selling price per unit of $9.80. The variable cost per unit is $4.20. What is the accounting breakeven level of production? Answer: 1,200 units
Question 32 

Douglass Enterprises has a capital structure which is based on 40 percent debt, 10 percent 

preferred stock, and 50 percent common stock. The aftertax cost of debt is 6 percent, the cost 

of 
preferred is 7 percent, and the cost of common stock is 9 percent. The company is 

considering a project that is equally as risky as the overall firm. This project has initial costs 

of 
$125,000 and cash inflows of $76,000 a year for two years. What is the projected net 

present value? Should this project be accepted or rejected? 

Answer: $11,275.07, yes 
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Question 36
After successful operating for a number of years, Spartan Co decides to increase even further
the leverage so that the debttoequity ratio becomes 1.2. What is the cost of capital?
Answer: 10.52%
R _{E} = 0.13 + (0.13 – 0.095)(1.2)(0.65) = 0.1573
If D/E = 1.2, D=1.2 & E=1.0, => w _{D} = 1.2/2.2, w _{E} =1/2.2
WACC = w _{E} R _{E} + w _{D} R (1t)
= (1.0/2.2) (0.1573) + (1.2/2.2) (0.095) (0.65) = 0.10518
Question 37 

Calculate the expected return of the portfolio: 

Asset 
Wealth invested 
E(Ri) 

A 
200 
15% 

B 
100 
20% 

C 
500 
10% 

Answer: 12.5% 
Question 38 

ABC limited have 50 000 shares outstanding that sell in the market for $17.50 each. Share’s 

beta coefficient is 1.2. The market risk premium is 8% and the riskfree rate is 5%. What is 

ABC limited’s cost of equity capital and the market value of equity? 

Answer: 14.6%, $875 000 
Question 39 

Uptown Interior design has the same market value as the book value of its balance sheet 

accounts. The firm has declared a dividend of $0.35 per share that will be paid in two days 

time. The company has 8,000 shares of stock outstanding trading in the market. The balance 

sheet is presented in the following table: 
Balance Sheet 

Cash 
25,000 
Equity 
190,000 

Fixed Assets 
165,000 

Total 
190,000 
Total 
190,000 
a) Ignoring taxes, what is the stock selling for today?
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Question 41 

Shirley’s and Son have a debtequity ratio of .60 and a tax rate of 35 %. The firm does not 

issue preferred stock. The cost of equity is 10 % and the cost of debt is 8 %. What is Shirley’s 

weighted average cost of capital? 

Answer: 8.2 % 

Question 42 

You are an investor in BHP and own 100 shares. BHP shares sell for $41. The company is 

about to pay a $1 dividend but you prefer a $3 dividend. What will you do to receive the 

desired income of $300? 

Answer: sell 5 shares ex dividend 
Question 43 

Today, you sold 200 shares of SLG Inc. stock. Your total return on these shares is 12.5 

percent. You purchased the shares one year ago at a price of $28.50 a share. You have 

received a total of $280 in dividends over the course of the year. What is your capital gains 

yield on this investment? 

Answer: 7.59 % 

1 
0 

28.5 
P0+1.4 
DPS = Div/shares = 280/200 = 1.4 

ret = (DPS+ch_P)/P_1 => 12.5% = (1.4 + P028.5)/28.5 => P0=30.66 

ch_P/P_1 = (P0P_1)/P_1 = (30.628.5)/28.5 = 7.59% 
Question 44
Caterpillar Inc. has 8 million shares of common stock outstanding, and 1.5 million 8% percent semiannual bonds outstanding, par value $100 each. The common stock currently sells for $25 per share, and has a beta of 1.25, and the bonds have 10 years to maturity and sell for
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Question 46 

Jack’s Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds 

with similar characteristics are yielding 8.5 %. Face value of a bond is $1000. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells 

for $40 a share. The U.S. Treasury bill is yielding 4 % and the market risk premium is 8 %. 

Jack’s tax rate is 35 %. What is Jack’s weighted average cost of capital? 

Answer: 10.38 % 
Question 47 Stark company has decided to restructure its capital. Currently, it uses no debt financing. Following the restructuring, debt will be $1 million. The interest rate on the debt will be 9%. The company currently has 200 000 shares outstanding and the price per share is $20. If the restructuring is expected to increase EPS, what is the minimum level of EBIT that the firm’s management must be expecting? Answer: $360 000
Question 48 

Strip Tavern has the cost of equity at 14% and the cost of debt at 6.5%. Assuming that the 

target debt/equity ratio is 50% and the company tax rate is 34%, calculate the overall cost of 

capital. 

Answer: 10.7% 

Question 48b 

The CanDo Co. is analysing a proposed project. The company expects to sell 12,000 units, 

plus or minus 4 percent. The expected variable cost per unit is $7 and the expected fixed cost 

is $36,000. The fixed and variable cost estimates are considered accurate within a plus or 

minus 6 percent range. The depreciation expense is $30,000 per year, over the 5 year life of 

the project, using the straight line. The tax rate is 34 percent. The sale price is estimated at 

$14 a unit, plus or minus 5 percent. a) What is the earnings before interest and taxes under the base case scenario? 
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b) What is the earnings before interest and taxes under a best case scenario?
c) What is the net income under the worst case scenario? d) What is the NPV under the base case scenario if required rate of return is 12%?
Answer: a) $18 000; b) $37,497.60; c) $278.78; d) $968.03
Question 49 

You purchased 200 shares of stock at a price of $36.72 per share. Over the last year, you have 

received total dividend income of $322. What is the dividend yield? 

Answer: 4.4% 
Question 50 Printing Equip Co. are considering a project that costs $180 000, has a 6 year life, and no salvage value. Assume that depreciation is straight line. The required return of Printing Equip is 10.5% on such projects. Sales are estimated at 28 000 units per year. Price per unit is $9, variable cost per unit is $3.20, and fixed costs are $35 000 per year. The tax rate is 35%.

What is the accounting breakeven point? 




Calculate the base case cash flow and NPV What is the degree of operating leverage? 



Suppose that you think that the sales projection is accurate only to within 15%. Evaluate the sensitivity of NPV to changes in that projection by showing the NPV in the best and 

worst case. 



Suppose the projections given are all accurate to within 4% except for sales volume, which is only accurate to within 10%. What are the upper and lower bounds for these projections? 
Answer:
a) 
11,207 units; b) $93,310, $220,503; c) 1.375; d) $288 466, $152 541 

e) 
Apply 10% to sales and 4% to the rest of variables. 
Question 51 

The Auto Group has 1,200 bonds outstanding that are selling for $980 each. Face value is 

$1000. The company also has 7,500 shares of preferred stock at a market price of $40 each. 

The common stock is priced at $32 a share and there are 32,000 shares outstanding. What is 

the weight of the preferred stock as it relates to the firm’s weighted average cost of capital? 

Answer: 
12% 
Question 52 

Telco Inc. has a beta of 1.3 and an expected return of 18%. Woollies Co. has a beta of 0.80 

and an expected return of 9.5%. If Treasury Bills yield a return of 5% and the market return is 

11.75%, which stock is under/overvalued relative to the other? Show why. 

Answer: Telco is undervalued relative to Woollies. 
Reward to risk ratio for each stock: [ E(r) – R _{f} ] / 

Telco: ( 0.18 – 0.05 ) / 1.3 = 0.10 

Woolies: ( 0.095 – 0.05 ) / 0.8 = 0.05625 

=> Woolies is overvalued, Telco is undervalued 
Examples of Short Questions in the exam:
What is the Portfolio Theory assumption?
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Investors prefer the portfolio with the highest expected return for a given variance, or, the lowest variance for a given expected return
Discuss the information effect or the signalling effect of dividends.
Dividends and Signals Asymmetric information – managers have more info about the health of the company than investors Information Content Effect > Changes in dividends convey information > Cause market reaction
 Dividend increases: Management believes it can be sustained, Expectation of higher future dividends, increasing present value, Signal of a healthy, growing firm
 Dividend decreases: Management believes it can no longer sustain the current level of dividends,
Expectation of lower dividends indefinitely; decreasing PV, Signal of a firm that is having financial difficulties
Explain and graphically show, together with the associated formulas, the M&M proposition I and II with taxes. Optimal capital structure is almost 100% debt, each additional dollar of debt increases the CFA of firm
What are some examples of direct bankruptcy costs? Administrative and legal costs
According to the CAPM, the expected return on a risky asset depends on three components. Describe each component, and explain its role in determining expected return.
1. The riskfree rate, _{R}_{f}
2. The market risk premium, E(RM)
3. The systematic risk of the asset relative to average, which we called its beta coefficient,
Rf
Explain the concept of ‘homemade dividend policy’.
Homemade Dividend Policy Investors will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends. Homemade Dividend Policy = Tailored dividend policy created by individual investors to undo corporate dividend policy
Discuss and graphically show with the associated formulas the Capital Structure Theory when the firm has debt but not taxes. There is no optimal capital structure in this case, as the capital structure has no influence on the firms value, without taxes, the total value is unaffected by its capital structure
What are some realworld factors that may cause one dividend policy to be preferable to another? Different Tax rates, flotation costs, dividend restrictions, desire for current income, uncertainty resolution
What is diversification? What is the variable that plays the most important role in reducing the portfolio risk?
The Principle of Diversification:
states that spreading an investment across many assets will eliminate some but not all of the risk. Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns Size of risk reduction depends on covariances between assets in the portfolio there is a minimum level of risk that cannot be diversified away and that is the systematic portion
Unsystematic risk is essentially eliminated by diversification, but systematic risk cannot be reduced by
a portfolio
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Define the three forms of market efficiency. What do we mean when we say the markets are efficient? Capital Market Efficiency
Efficient Capital Markets: A market in which security prices reflect available information → based on available information, there is no reason to believe that the current price is too low or too high. efficient markets hypothesis (EMH): The hypothesis that actual capital markets, such as the NYSE, are efficient.
It means that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns 3 forms:
 weak form efficiency:
 Prices reflect all past market information such as price and volume
 investors cannot earn abnormal returns by trading on market information
 Implies that technical analysis will not lead to abnormal returns
 Empirical evidence indicates that markets are generally wfe
 semistrong form efficiency:
 Prices reflect all publicly available information including trading information, annual reports, press releases, etc.  investors cannot earn abnormal returns by trading on public information → fundamental analysis will not lead to abnormal returns
 strong form efficiency:
 Prices reflect all information, including public and private
 investors could not earn abnormal returns regardless of the information they possessed
 Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns
What are the lessons learned from capital market history? Lessons from Capital Market History
 Data reflects two features often observed in financial markets:  There is a reward for bearing risk.  The larger the potential reward, the larger the risk.
 This is called the riskreturn tradeoff
 There is a positive relationship between risk and return
Explain the meaning of the dividend clientele effect and why it is important.
Clientele Effect Some investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payouts Some investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts → If a firms changes the dividend policy from low to high or vice versa, it doesn’t matter, it just changes its structure of investors
What are the components of total risk? Give examples of each.
Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure of total risk For welldiversified portfolios, unsystematic risk is very small → almost = to the systematic risk
Systematic or unsystematic Risk
Systematic or NonDiversifiable Risk, market risk: That portion of an asset’s risk attributed to the market factors that affect all firms and cannot be eliminated through the process of diversification. Unsystematic or Diversifiable Risk assetspecific risk: That portion of an asset’s risk which is firm specific and can be eliminated through the process of diversification
What is CAPM? In equilibrium, what does CAPM implies?
Shows the relationship between systematic risk and expected return Positive slope The higher the risk, the higher the return According to the CAPM, all stocks must lie on the SML, otherwise they would be under or overpriced. In equilibrium, all assets and portfolios must have the same rewardtorisk ratio and they all must equal the rewardto risk ratio for the market, If not, assets are undervalued or overvalued
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What are other approaches of estimating the cost of capital of a project when the project is not of the same risk as the overall risk of the firm?
Other approaches to estimating a discount rate:
 divisional cost of capital—used if a company has more than one division with different levels of risk;
 pure play approach —a discount rate that is unique to a particular project is used; Look at companies in the same line of business as the new project Calculate an average WACC for all the companies and use this rate as the discount rate of the new project
 subjective approach —projects are allocated to specific risk classes which, in turn, have specified discount rates Consider the project’s risk relative to the firm overall risk If the project risk > firm risk, use a discount rate > WACC If the project risk < firm risk, use a discount rate < WACC
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