Hong Kong University of Science and Technology

FINA2303 Financial Management

Final Mock Examination
Spring 2015

There are 35 multiple choice questions. Please write your answers on the multiple choice
answer sheet provided. Each question carries 1 mark.

Question 1
Which of the following investment criteria in capital budgeting does NOT take into account
the time value of money?

I. The average accounting return rule.

II. The payback period rule.
III. The profitability index rule.
IV. The internal rate of return rule.

A. I and II only.
B. II and III only.
C. I, III and IV only.
D. I, II, III and IV.

Explanation
I and II do not consider the time value of money while III and IV do. The best answer is A.

Question 2
The senior management of a company has set a cutoff period of 2 years. The company is
considering a project with an initial investment of $2,000,000 and a cash inflow of
$1,000,000 and $1,500,000 in years 1 and 2 respectively. The payback period of the project
is and the company undertake the project under the payback period rule.

A. 1.33 years; should

B. 1.33 years; should not
C. 1.67 years; should
D. 1.67 years; should not

Explanation
payback period = 1 + ($2,000,000 - $1,000,000)/$1,500,000 = 1.67 years
As the payback period of the project is less than the specified cutoff period, the company
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should undertake the project. The best answer is C.

Question 3
The financial manager of a company is considering three mutually exclusive projects.

Project Initial investment in year 0 Cash inflow in year 1 Cash inflow in year 2
I -$1.0 million $0.60 million $0.60 million
II -$1.5 million $0.85 million $0.85 million
III -$2.0 million $1.15 million $1.15 million

Given that the discount rate for all three projects is 15%, which of the projects should be
chosen based on the profitability index rule?

A. None of the projects

B. I
C. II
D. III

Explanation
cash inflow in cash inflow in PV of cash
initial investment in profitability
project year 1 ($ year 2 ($ inflows ($
year 0 ($ million) index
million) million) million)
I -1.00 0.60 0.60 0.98 0.98
II -1.50 0.85 0.85 1.38 0.92
III -2.00 1.15 1.15 1.87 0.93
As the profitability index of all three projects is less than 1, the decision is not to undertake
any project. The best answer is A.

Question 4
A company has two mutually exclusive projects X and Y with the following cash flow
patterns:

Project Initial investment Cash flow in year 1

X $1,000,000 $1,250,000
Y $1,200,000 $1,480,000

What is the cross-over discount rate that makes the two projects indifferent to the company
based on the net present value rule?

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A. 12%
B. 15%
C. 18%
D. 21%

Explanation
$1,250,000/(1+r) - $1,000,000 = $1.480,000/(1+r) - $1,200,000
r = 15%
The best answer is B.

Question 6
Arrange the following steps in the capital budgeting process for a project in the order of time
sequence (“>” means “occurs earlier than”):

I. Talk to the salespersons to forecast sales and expenses associated with the project.
II. Prepare the pro forma financial statements of the project.
III. Estimate the net cash flows generated by the project.
IV. Carry out the post audit for the project.

A. I > II > III > IV

B. II > IV > I > III
C. IV > II > I > III
D. II > IV > III > I

Explanation
The steps according to the time sequence should be I > II > III > IV. The best answer is A.

Question 7
Which of the following statements describes a situation that is NOT considered as
appropriate when applying the net present value rule in capital budgeting?

I. A financial manager estimates the before-tax cash flows of a project and discounts them
at the before-tax discount rate.
II. In considering two mutually exclusive projects, a financial manager subtracts the cash
flows of one project from those of another project. Based on the net present value of
this net cash flow stream, he makes a decision to choose between these two projects.
III. A financial manager includes the depreciation tax shield as a relevant cash inflow in a
project.
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IV. When calculating the corporate income tax paid to the government in a capital budgeting
exercise, a financial manager uses the accounting methods used in preparing the
financial statements.

A. I and IV only.
B. I, II and III only.
C. II, III and IV only.
D. I, II, III and IV

Explanation
A financial manager should estimate the after-tax cash flows of a project and discounts them
at the after-tax discount rate. Hence, I is not appropriate.
When calculating the corporate income tax paid to the government in a capital budgeting
exercise, a financial manager should use the accounting methods used in preparing the tax
return, i.e. tax reporting. Hence, IV is not appropriate.
The best answer is A.

Question 8
In undertaking a project of launching a new product, the senior management of a company
expects that it will increase the traffic of the customers. As a result, some new customers
will buy some of the old products from the company and the sales revenue of the old products
increases. Which of the following statements best describes this situation?

A. It is not considered as a relevant cash flow because it is a sunk cost.

B. It is considered as a relevant cash flow because it is an opportunity cost.
C. It is considered as a relevant cash flow because it is an incidental effect.
D. It is considered as a relevant cash flow because it is part of the change in net working
capital.

Explanation
The increased traffic is an incidental effect. The best answer is C.

Use the following information to answer questions 9 through 12. The chief financial officer
of a company prepares the following pro forma financial statements for a 3-year project on
the standalone principle:

Pro-Forma Statement of Financial Position

Year 0 1 2 3

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Net working capital $600,000 $600,000 $600,000 $600,000
Net fixed assets $1,800,000 $1,200,000 $600,000 $0
Total investment $2,400,000 $1,800,000 $1,200,000 $600,000

Pro-Forma Income Statement (the same for each of Years 1 to 3)

Sales $4,400,000
Cost of goods sold (COGS) 2,200,000
Other expenses 400,000
Depreciation 600,000
Earnings before interest and taxes (EBIT) $1,200,000
Interest expense 360,000
Income before tax $840,000
Income tax expense 252,000
Net income $588,000

Assume that the straight line depreciation method is used for both financial reporting and tax
reporting. In other words, the net book value of the fixed assets is equal to $0 at the end of
the project. The corporate tax rate is 30%. The fixed assets are expected to sell for
$100,000 at the end of the project. All these cash flows are estimated on the real basis.

Question 9
Which of the following statements best describes the standalone principle?

A. It refers to the assumption that a project is considered as an independent project and the
investment decision on it does not depend on the decision of another project.
B. It refers to the assumption that a project is evaluated based on the project’s incremental
cash flows as if it is a “mini-firm”
C. It refers to the assumption that a project is evaluated based on the direct relevant cash
flows without taking into consideration all other side effects associated with the project.
D. It refers to the assumption that the net present value of a project is always unique as
compared to the potential multiple solutions in the internal rate of return (IRR) rule.

Explanation
The standard principle refers to the assumption that the evaluation of a project can be based
on the project’s incremental cash flows as if it is a “mini-firm”. The best answer is B.

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Question 10
Calculate the annual operating cash flows for Years 1 to 3.

A. $588,000
B. $840,000
C. $1,200,000
D. $1,440,000

Explanation
annual operating cash flows = $1,200,000*(1-30%) + $600,000 = $1,440,000
The best answer is D.

Question 11
What is/are the relevant cash flow(s) relating to the change in net working capital for this
project?

A. There is no incremental cash flow as the net working capital is kept constant in all the
years.
B. A cash inflow of $600,000 in year 0 and a cash outflow of $600,000 in year 3.
C. A cash outflow of $600,000 in year 0 and a cash inflow of $600,000 in year 3.
D. A cash outflow of $600,000 in year 0 only.

Explanation
This project involves a cash outflow of $600,000 in year 0 and a cash inflow of $600,000 in
year 3 due to the change in the net working capital. The best answer is C.

Question 12
Determine the net relevant cash flow relating to the disposal of the fixed assets at the end of
the project.

A. $130,000
B. $100,000
C. $70,000
D. $0

Explanation
Net relevant cash flow = $100,000 – ($100,000 - $0)*30% = $70,000
The best answer is C.

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Question 13
The financial manager of a company finds that it has to rent a new storage facility to
accommodate the additional finished goods produced in a project. He also decides to
redeploy one of the two existing employees for storage to work in this new storage facility.
Which of the following statements is appropriate when considering whether it is a relevant
cash flow?

I. The rent of the new storage facility is a relevant cash flow.

II. The rent of the new storage facility is NOT a relevant cash flow.
III. The salary of the redeployed employee is a relevant cash flow.
IV. The salary of the redeployed employee is NOT a relevant cash flow

A. I and III only.

B. I and IV only.
C. II and III only.
D. II and IV only.

Explanation
The rent of the new storage facility is a relevant cash flow because it is incremental. The
salary of the redeployed employee is not a relevant cash flow because it is non-incremental.
The best answer is B.

Question 14
A company considers a project which is expected to generate a cash flow of $300,000,
$200,000 and -$50,000 in years 1, 2 and 3 respectively. The initial investment of the project
in year 0 is $400,000 and the company requires a rate of return of 12% for bearing the project
risk. The project’s net present value is and the decision is to the project
based on the net present value rule.

A. -$8,293; reject
B. -$1,786; reject
C. $1,786; accept
D. $8,293; accept

Explanation
NPV = $300,000/(1+12%) + $200,000/(1+12%)2 - $50,000/(1+12%)3 - $400,000 = -$8,293
As the NPV is less than zero, the decision is to reject the project. The best answer is A.

Question 15
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Which of the following is considered as a use of post audit in the capital budgeting exercise?

I. To identify the actual problems arisen from the implementation of the project.
II. To check for forecasting accuracy by comparing the actual results with the financial
plan.
III. To improve the next round of capital budgeting exercise through feedback.
IV. To suggest plausible remedial actions to improve the current situation of the project.

A. I, II and III only.

B. I, II and IV only.
C. II, III and IV only.
D. I, II, III and IV.

Explanation
All of them are uses of post audit. The best answer is D.

Question 16
Carol is a first-time investor. She prefers more wealth to less and she is risk-averse. Given
that she has to choose one of the following portfolios, which is the best portfolio for her?

Portfolio Expected return Standard deviation of returns

I 8% 18%
II 9% 22%
III 10% 22%
IV 11% 18%

A. Portfolio I.
B. Portfolio II.
C. Portolio III.
D. Portfolio IV.

Explanation
As portfolio IV offers the highest return at the lowest risk, it is the best portfolio for Carol.
The best answer is D.

Question 17
A portfolio consists of two individual assets, I and II, with the following data:

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 Individual asset Standard deviation of returns Weight in portfolio
I 12% 40%
II 15% 60%

The correlation between the returns on I and II is -0.5. Calculate the standard deviation of
returns on the portfolio.

A. 6.50%
B. 7.80%
C. 11.53%
D. 13.30%

Explanation
standard deviation of returns on the portfolio
= (12% * 40%) 2 + (15% * 60%) 2 + 2 * 40% * 60% * ( −0.5) *12% * 15%
= 7.80%
The best answer is B.

Question 18
Which of the following is an unsystematic risk factor which is specific to a particular
company?

I. The relationship between the return on a company’s stock and the return on a stock
market index.
II. The quality of the management of a company.
III. The total debt ratio of a company.
IV. The business nature of a company.

A. I, II and III only

B. I, II and IV only
C. II, III and IV only
D. I, II, III and IV

Explanation
The relationship between the return on a company’s stock and the return on a stock market
index shows the systematic risk. Hence, I is not an unsystematic risk factor. All the others
are unsystematic risk factors. The best answer is C.

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Question 19
The Tracker Fund mimics the composition of the Heng Seng Index, i.e. the stock market
index in Hong Kong. An investor should be concerned about its:

A. volatility.
B. total risk.
C. unsystematic risk.
D. systematic risk.

Explanation
The Tracker Fund is a well-diversified portfolio and an investor should be concerned about its
systematic risk. D is the best answer.

Question 20
A security analyst has collected the following financial data of Beauty Salon Company
Limited:

Beauty Salon’s beta: 1.25

the yield on government bond: 4%

the market risk premium = 8%

The security analyst uses a financial model to estimate the expected return on Beauty Salon
to be 12.5%. Based on the capital asset pricing model, the required rate of return on Beauty
Salon is . By comparing Beauty Salon’s required rate of return and expected return,
it is recommended to its shares.

A. 9%; buy
B. 9%; sell
C. 14%; buy
D. 14%; sell

Explanation
Beauty Salon’s required rate of return = 4% + 1.25*8% = 14%
As the required rate of return (14%) is higher than the expected return (12.5%), it is
recommended to sell the stock.
The best answer is D.

Question 21
Super Nanotechnology, a Hong Kong based company, has the following two projects:
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 Project Description
I An expansion project that the company will expand its production
facilities to enlarge its output level of the existing products in Hong
Kong. Hopefully, it can take advantage of the economy of scale to
reduce the production costs.
II An expansion project that the company will build up new distribution
channels in Mainland China. Hopefully, it can take advantage of the
huge population in the Mainland to enhance its sales revenue.

The chief financial officer of the company has collected the relevant data and has calculated
the following two possible discount rates (weighted average costs of capital, WACC):

Discount rate How to calculate it

X Collected the financial data based on Super Nanotechnology and
calculated the WACC.
Y Collected the financial data based on a Mainland Chinese company similar
to Super Nanotechnology in terms of business nature, size and other
characteristics, and calculated the WACC.

Which is/are the appropriate discount rate(s) to be applied to projects I and II?

A. Discount rate X for both projects I and II.

B. Discount rate Y for both projects I and II.
C. Discount rate X for project I and discount rate Y for project II.
D. Discount rate Y for project I and discount rate X for project II.

Explanation
Project I involves an expansion of the current production facility similar to the existing assets
of the company in terms of risk. Discount X is the appropriate discount rate for project I.
Project II involves an expansion into a new market which is expected to have a different risk
from the existing assets of the company. Discount Y is the appropriate discount rate for
project II. The best answer is C.

Question 22
Which of the following estimates is required by a company in applying the sustainable
growth model to determine the cost of equity?

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I. The beta of the company’s stock.
II. The market risk premium.
III. The retention ratio.
IV. The return on equity.

A. I and II only.
B. III and IV only.
C. I, II and IV only.
D. II, III and IV only.

Explanation
I and II are required by applying the capital asset pricing model. III and IV are required by
applying the sustainable growth model. The best answer is B.

Use the following information to answer questions 19 through 20. A company has two
sources of finance, debt and common stock. The financial manager of the company has
collected the following data:

The optimal debt-equity ratio set by the company: 2/3

The company’s cost of equity: 15%

The prevailing market interest rate for the company’s debt: 8%

The marginal tax rate: 30%

The financial manager has also estimated the following net cash flows for a project:

year 0 1 2 3
net cash flows -$500,000 $250,000 $300,000 $350,000

Question 23
Calculate the weighted average cost of capital (WACC) of the company?

A. 8.73%
B. 10.33%
C. 11.24%
D. 12.20%

Explanation
weight of debt = 2/3 / (2/3+1) = 40%

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weight of common stock = 1 – 40% = 60%
WACC = 8%*(1-30%)*40% + 15%*60% = 11.24%
The best answer is C.

Question 24
Suppose that the above WACC is the appropriate discount rate for the project. Calculate the
net present value (NPV) of the project.

A. $208,916
B. $221,441
C. $233,608
D. $255,922

Explanation
NPV = $250,000/(1+11.24%) + $300,000/(1+11.24%)2 + $350,000/(1+11.24%)3 - $500,000
= $221,441
The best answer is B.

Question 25
Which of the following investors usually provides the seed money to a newly established
company in its financing cycle?

I. The founder of the company.

II. The founder’s family, her friends and other fools.
III. The angel investors.
IV. The general public.

A. I, II and III only.

B. I, II and IV only.
C. I, III and IV only.
D. II, III and IV only.

Explanation
I, II and III are potential investors in the ownership interest of a newly established company.
IV is not likely to take part in contributing the capital to the company at the seed stage. The
best answer is A.

Question 26
If a company issues new shares and sells them to a selective group of institutional and high
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net worth investors, it is known as:

A. a seasoned offering.
B. a private placement.
C. a secondary offering.
D. an initial public offering.

Explanation
This is the definition of a private placement. The best answer is B.

Question 27
Which of the following is often considered as the cheapest source of financing?

A. Issue of new debt.

B. Issue of new common stock.
C. Issue of preferred stock.
D. Internally generated funds.

Explanation
Internally generated funds usually provide the cheapest source of financing. The best
answer is D.

Question 28
Which of the following statements is correct with respect to the financing decisions made by
a company?

I. Corporate financing deals with the issue of obtaining funds by a firm for investment
activities.
II. Capital structure deals with the choice of a firm’s mix of debt and equity.
III. Dividend policy determines the amount of internally generated funds available to a firm.
IV. Tax-deductible interest expenses are a factor against new debt issue with which a firm
wants to finance a project.

A. I, II and III only

B. I, II and IV only
C. I, III and IV only
D. II, III and IV only

Explanation
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Tax-deductible interest expenses are a factor in favor of new debt issue with which a firm
wants to finance a project. Hence, IV is not correct. The best answer is A.

Question 29
Which of the following statements best describes the role played by a sponsor in the initial
public offering (IPO) of a company?

A. The sponsor is responsible for buying the newly issued securities from the company and
reselling them to the investors.
B. The sponsor is responsible for giving advice to the company in relation to all compliance
matters.
C. The sponsor is responsible for maintaining the stability of the stock price within 30 days
after the shares of the company are publicly traded on the stock exchange.
D. The sponsor is responsible for carrying out the due diligence process, coordinating the
activities relating to the IPO and submitting the relevant documents to the stock
exchange on behalf of the company.

Explanation
The sponsor is responsible for carrying out the due diligence process, coordinating the
activities relating to the IPO and submitting the relevant documents to the stock exchange on
behalf of the company. The best answer is D.

Question 30
In an initial public offering, a financial institution buys the shares from the issuer and resells
them to investors. In case that the shares are undersubscribed, the financial institution has to
keep the remaining shares. This financial institution plays the role of:

A. a transfer agent.
B. a distributor.
C. a sponsor.
D. an underwriter.

Explanation
The financial institution is an underwriter. The best answer is D.

Question 31
The provision that allows the underwriters of an initial public offering (IPO) of a company to
buy additional shares from the company at the offer price to cover over-allotments is known
as:
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A. the lock-up agreement.
B. the price stabilization action.
C. the underpricing.
D. the green shoe option.

Explanation
The provision that allows the underwriters of an initial public offering (IPO) of a company to
buy additional shares from the company at the offer price to cover over-allotments is known
as the green shoe option. The best answer is D.

Question 32
Which of the following is often considered as a short-term source of finance to a company?

I. An overdraft facility.
II. A line of credit.
III. Factoring of accounts receivable.
IV. A term loan.

A. I, II and III only.

B. I, II and IV only.
C. I, III and IV only.
D. II, III and IV only.

Explanation
I, II and III are working capital facilities while IV is a long-term source of finance to a
company. The best answer is A.

Question 33
Which of the following is a direct bankruptcy cost?

I. The legal expenses of the bankruptcy proceeding

II. Sales lost during the bankruptcy proceeding.
III. The administrative expenses of with the bankruptcy proceeding.
IV. Employees leaving the company during the bankruptcy proceeding.

A. I and III only.

B. II and IV only.
C. I, II and III only.
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D. I, II, III and IV.

Explanation
I and III are direct bankruptcy costs while II and IV are indirect ones. The best answer is A.

Use the following information to answer questions 34 through 35. The cum-rights stock price
is $25. A company announces a 1 for 3 rights issues where the subscription price is $22.

Question 34
Which of the following statements is correct after the rights are exercised?

I. The number of shares outstanding increase

II. The net asset value of a company decreases.
III. The stock price decreases.

A. I and II only.
B. I and III only.
C. II and III only.
D. I, II and III.

Explanation
As a company receives the subscription price from the shareholders, the net asset value of the
company increases. Hence, II is not correct. The best answer is B.

Question 35
Calculate the ex-rights stock price per share.

A. $18.75
B. $22.75
C. $23.50
D. $24.25

Explanation
ex-rights stock price = ($25*3 + $22*1)/(3+1) = $24.25
The best answer is D.

- The End -

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