FNCE10002 Principles of Finance Semester 1, 2019

FNCE10002 Principles of Finance

Semester 1, 2019
Sample Final Exam 1

The reading time for this sample exam is 15 minutes and the writing time is 120 minutes. On this
semester’s final exam you will be required to write your answers in the exam booklet and you will be
provided with adequate space to do so. Note also that the format of this semester’s final exam may differ
from this sample exam’s format. Further details on the format of this semester’s final exam will be
available via the LMS. Suggested answers to these questions will be made available in due course via
the LMS.

Question 1 [4  5 = 20 marks]

This question consists of five multiple choice questions. For each question pick the most reasonable
response based only on the information provided.

a) Which of the following statements about capital budgeting analysis are most likely to be true?

I. A necessary condition for multiple internal rates of return is that the future cash flows
change sign at least two times.
II. Financing costs such as dividends paid to shareholders should be included in the estimation
of a project’s net cash flow.
III. Financing costs such as interest on debt should not be included in the estimation of a
project’s net cash flow.

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

b) Which of the following statement(s) is (are) most likely to be true?

I. The total value of a firm is defined as the market value of its equity plus the net present
value of all its investment projects.
II. In the context of a firm’s capital structure decision, Modigliani and Miller’s proposition 1
states that the value of the firm’s equity does not change regardless of the level of debt in
its capital structure.

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

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FNCE10002 Principles of Finance Semester 1, 2019

c) A firm currently has $100 million in debt outstanding with a 10% interest rate. The terms of the
loan require the firm to repay $25 million of the debt outstanding each year. The firm’s marginal
corporate tax rate is 40% and that the interest tax shields have the same risk as the loan. The
present value of the interest tax shields from this debt is closest to:

A. $8.3 million.
B. $10.0 million.
C. $25.0 million.
D. None of the above.

Parts (d) and (e) are based on the following information.

You are given the following information on two stocks and the market portfolio.

Variances and Covariances

Security/Portfolio Alpha Ltd Market Portfolio
Alpha Ltd 0.040
Market Portfolio 0.015 0.010

d) The beta of Alpha Ltd is closest to:

A. 0.38.
B. 0.67.
C. 1.50.
D. 3.00.

e) If the expected return of Alpha Ltd is 15% and the riskfree rate is 6% then the market risk
premium is closest to:

A. 6.0%.
B. 9.0%.
C. 10.0%.
D. None of the above.

Question 2 [4 × 3 = 12 marks]

State whether the following statements are consistent or inconsistent with the CAPM and provide a
briefly explanation.

a) A security with only diversifiable risk has an expected return that exceeds the riskfree rate of
return.

b) A security with a beta of 1.0 earned a return of 15% last year when the market portfolio earned
a return of only 9%.

c) Small-sized firms with equity betas of 1.5 are expected to earn higher returns on average than
large-sized firms with the same beta.

Question 3 [10 + 2 + 4 + 6 = 22 marks]

The finance manager of Megacorp Ltd has approached you for assistance with the firm’s capital
budgeting process. At your request, she has provided you with the following information in relation to
the firm’s finances. Some years ago, the firm issued 100,000 bonds (each with a $100 face value)
bearing a coupon rate of 7% paid annually. These bonds are currently trading on the market at their face
value. A coupon payment relating to the bonds was made yesterday and the bonds will mature three
years from today. The firm has 20 million ordinary shares on issue and they are currently trading at

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FNCE10002 Principles of Finance Semester 1, 2019

$1.50 per share. The beta of the ordinary shares has been estimated at 1.2, the rate of return on 10-year
Commonwealth bonds is currently at 5% and the market risk premium has been estimated at 8%.

a) Calculate Megacorp Ltd’s before-tax weighted average cost of capital. Show all calculations.

b) The following investment projects are being considered by Megacorp. All projects are
independent and are in Megacorp’s usual line of business. Assume that the NPVs of the projects
were calculated using the weighted average cost of capital obtained in part (a).

Project Initial Outlay IRR NPV

A $450,000 17.0% $18,800
B $128,000 19.5% $2,300
C $262,000 16.2% $10,800
D $180,000 12.0% –$7,000
E $240,000 17.5% $22,500
F $160,000 11.3% –$9,000

Indicate which projects the firm should undertake and why. Assume that the firm faces no
capital constraint.

c) How would your answer in part (b) change if projects A, B and C were mutually exclusive and
if projects D, E and F were also mutually exclusive. Assume that projects A, B and C can be
analyzed independently of projects D, E and F and that the firm faces no capital constraint.

d) How would you respond to someone who argues that if Megacorp is considering a project, in
its usual line of business, which will be financed entirely by a new bond issue, the cost of debt
is the appropriate hurdle rate for this project? Explain.

Question 4 [10 + 4 = 14 marks]

Sid Neigh owns 2,000 shares in Arepo Ltd, which is a company listed on the ASX. The current price of
Arepo’s shares is $9.00 per share. There are also put and call options traded on Arepo shares with each
option contract covering 100 shares. Sid sells 20 one-month call options with an exercise price of $10.00
per share and buys 20 one-month put options with an exercise price of $8.00 per share. He intends to
sell his shares in one month’s time.

a) Complete the following table. Show your calculations for the first two and the last two rows.

Price per Total payoff Total payoff

share in one Total value of from the 20 from the 20 Total cash
month’s shares in one call contracts put contracts flow in one
time month’s time sold bought month’s time
$6.00
$7.00
$8.00
$9.00
$10.00
$11.00
$12.00

b) Describe the effect(s) of Sid’s option strategy on the returns he would otherwise have made. Is
Sid likely to be a highly risk averse or less risk averse investor? Explain.

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FNCE10002 Principles of Finance Semester 1, 2019

Question 5 [10 marks]

In the context of a firm’s capital structure decisions, a famous proposition by Modigliani and Miller
implies the following relationship:

 D
rE  rO  (rO  rD )   .
E

Identify the proposition and explain each of the components in the expression above. Provide an
intuitive interpretation of this proposition.

Question 6 [3 + 6 + 7 + 6 = 22 marks]

TLT Ltd is considering the purchase of a new machine for use in its production process. Management
has developed three alternative proposals to help evaluate the machine purchase. Only one of these
proposals can be implemented.

Proposals A and B both have the same cost to set up, but the output from proposal A (as measured by
future net cash flows) commences at a high rate and then declines over time, while Proposal B starts at
a low rate and then increases over time. Proposal C involves buying two of the machines considered
under proposal B. That is, proposal C is simply Proposal B scaled by a factor of two. Proposal C results
in net cash flows which are similar in magnitude to proposal A’s net cash flows in the first two years.

The estimated net cash flows, internal rates of return and net present values at 9% and 11% for each
proposal are given in the following table.

End of Year Proposal A Proposal B Proposal C

0 -$290,000 -$290,000 -$580,000
1 $100,000 $40,000 $80,000
2 $90,000 $50,000 $100,000
3 $80,000 $60,000 $120,000
4 $70,000 $70,000 $140,000
5 $60,000 $80,000 $160,000
6 $50,000 $90,000 $180,000
7 $40,000 $100,000 $200,000
Sum of cash flows $200,000 $200,000 $400,000
Internal rate of return 18.2% 12.8% (i)
NPV (at 9%) $79,549 $45,064 (ii)
NPV (at 11%) $59,348 $20,359 (iii)

a) For proposal C, what is: (i) the internal rate of return, (ii) the net present value at a discount rate
of 9% and (iii) the net present value at a discount rate of 11%?

b) Sketch the NPV profile for proposals A, B and C. Assume a linear relation between net present
value and the discount rate (that is, use straight lines to connect the coordinates on the x and y
axes). Mark all the relevant crossover point(s) on your sketch.

c) (i) If the required rate of return for NPV and IRR analysis is 9%, which proposal would
you recommend and why?

(ii) If the required rate of return for NPV and IRR analysis is 11%, which proposal would
you recommend and why?

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FNCE10002 Principles of Finance Semester 1, 2019

(iii) Give possible reasons for any apparent conflict between the recommendations made
using the net present value and internal rate of return methods. If there is no conflict
explain why this is the case.

d) Calculate the payback period for each proposal. Would the proposal with a shorter payback
period be more “profitable” than one with a longer payback period? Explain.

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FNCE10002 Principles of Finance Semester 1, 2019

Formula Sheet for Sample Final Exam

FVn
FVn  PV0 (1 n r) PV0 
(1  n  r )
F Vn
FVn  PV0 (1 r)n PV 0 
(1  r ) n

C  C  1 
PV0  PV0     
 r   1  r  
n
r

 C  1  C 
 (1  r ) 1
n
PV0(OA) =   1  n  FVn(OA) = 
 r   (1  r )  r
 C  1  C
 1  r  FVn ( AD)    1  r  1 1  r 
n
PV0 ( AD)    1 
 r   1  r 
n
 r  

C1  C  (1  g ) n 
PV0  PV0 ( GA )   1   1  

rg rg 1  r 
n
 
 C1   (1  g )n   r
m

n 
 1 r 
n
FVn (GA)    1  re  1    1
 r  g   1  r    m
Fn
re = er – 1 P0 
[1  ( n / 365)  rD ]
n  
 C  1  Fn Dt Pn
P0     1   P0    
 rD   (1  rD )
n
 (1  rD )
n

t 1 1  rE 
t
 1  r n
  E

Dn1 Pn1  Pn D
rE   Pn  n1
Pn Pn rE  g
D Dn1
rE  n1  g g  rE 
Pn Pn
P0  P0  (1  g )
 
E1 rE  g E0 rE  g
P  Dt  Pt 1 P  Ct  Pt 1
Rt  t Rt  t
Pt 1 Pt 1
/
⋯ / 1 1 … 1 1

(1 + r) = (1 + rr)(1 + i) E(r) = p1R 1 + p2R 2 + ... + pnRn

Var(r) or 2 = p1[R1 – E(r)]2 + ... + pn[Rn – E(r)]2 SD(r) = 

12 = p1[r11 – E(r1)][r21 – E(r2)] + ... +  12

12 
pn[r1n – E(r1)][r2n – E(r2)]  1 2
 12   1 2  12 E(rp) = x1E(r1) + x2E(r2)
 p2  x1212  x22 22  2x1x212  p2  x1212  x22 22  2x1x21 2 12
 2  N 1 
 p2     jk  E(rj) = rf + [E(rm) – rf]j
N  N 

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FNCE10002 Principles of Finance Semester 1, 2019

Formula Sheet for Sample Final Exam

 jm j 
j   j   jm  
 m2 m 
p = x11 + x22 S = [E(rp) – rf]/σp
T = [E(rp) – rf]/βp A = rp – [rf + [E(rm) – rf]βp]
N
Ct N
Ct
NPV    I0 NPV  0    I0
1  r  1  IRR 
t t
t 1 t 1

PI = NPV/I0 Ct = (Rt – OCt)(1 – tc) + tcDt

 (1  r ) N   D E  P
NPV  NPV0   rO  rD    rE    rP   
 (1  r )  1 
N
V  V  V 
 D E  P
rO '  rD (1  tc )    rE    rP   VU = EBI/rO
V  V  V 
EL = (EBI – Interest)/rE DL = Interest/rD
 D
VL = EL + DL rE  rO   rO  rD   
E
D
 E  O   O   D    VL = VU + tc × D
E
VL = VU + PV(TS) – PV(BC + AC) X + mP1 = nD1 + I
V0 = [(n + m)P1 – I + X]/(1 + rE) Call option payoff = Max(ST – X, 0)
Call option profit = Max(ST – X, 0) – C Put option payoff = Max(X – ST, 0)
Put option profit = Max(X – ST, 0) – P

Sample Final Exam 1 7