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FINANCE COMM 308/2 A, AA, B, BB, C, D, E
EXAMINATION DATE TIME # OF PAGES 16
Final Exam December 19, 2009 3 hours including cover
VERSION GREEN
INSTRUCTOR: DIVISION
(Î Underline your instructor’s name) John Molson School of Business
D. Newton Concordia University
R. Jassim
R. Mateti
J. Riley
T. Walker

READ THESE SPECIAL INSTRUCTIONS CAREFULLY 
 
‐ You are allowed one 8.5x11 sheet of paper (double sided); You may write, type, draw or 
copy anything on this sheet. 
 
‐ This is Version GREEN of the test. You must submit a GREEN computer answer sheet.  
 
‐ For Multiple Choice Questions,  
             All answers must be recorded IN PENCIL on the computer sheet. 
 
‐ For Problems:  
            All answers must be recorded within this exam.  
            Show your calculations to earn part marks. Write in the space provided. 
 
‐  Cell phones must be turned off, programmable calculators and PDAs are not allowed. 
 
‐  Please ensure you have 16 pages (including cover) in this exam.  
 
‐  Fill in your name and other required information IN PENCIL on the Computer Answer 
sheet as well as on this cover sheet. 
‐   Blank questions or those with multiple answers will not receive credit. 
‐   Translation dictionaries are allowed if approved by professor at start of exam. 

REMINDER: Put your Name and ID on (1) this exam; (2) computer answer sheet and (3) 
Your Crib Sheet. Hand in this exam, computer sheet and your Crib Sheet.

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 Multiple Choice: answer on the GREEN computer answer sheet

Part I: Multiple Choice Questions (25 Questions, 70 Points Total):

- This part consists of 10 concept questions and 15 calculation problems.

- Each concept question counts 2.5 points for a total of 25 points and each calculation problem counts
3 points for a total of 45 points.
- Only answers on the computer answer sheet will be graded.
- Use a pencil to mark your answers.
- Select only one answer per question, blank or multiple answers will not receive credit.
- You are encouraged to also circle your answer on the exam sheet as a back up.

A. Concept Questions (10 Questions, 2.5 Points Each)

1. The total financial leverage of a firm includes:

I. Common equity
II. Inventory
III. Accounts payable
IV. Accounts receivable
A) I. only
B) I and II
C) II and IV only
D) III only
E) II, III and IV

2. The principle of diversification states that spreading an investment over a number of assets will
eliminate:
A) All the systematic risk and some of the unsystematic risk
B) All the unsystematic risk and some of the systematic risk
C) Most of the systematic risk
D) Most of the unsystematic risk

3. If the cost of equity for a firm is 5% then increasing the retention ratio will increase the stock price
if (choose best answer):
A) The firm is able to earn a return of less than 5% on its equity
B) The firm is able to earn a return of more than 5% on its equity
C) Increasing the retention ratio will never increase stock prices
D) Increasing the retention ratio will always increase stock prices

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 Multiple Choice: answer on the GREEN computer answer sheet

Questions 4 and 5 use Figure 1.

Figure 1

15
10
5
0
-5 0 10 20 30 40
$

-10
-15
-20
-25
-30
Value of underlying asset

4. Figure 1 represents the profit to _________ a ________ .

A) Buying, put
B) Selling, put
C) Buying, call
D) Selling, call

5. The strike price of the option in figure 1 is __________ and the initial cost of the option is _______
A) 25, 10
B) 10, 25
C) 35, 10
D) 10, 35

6. Consider the following two statements:

I. A firm’s sustainable growth rate (g) decreases with higher profit margins, higher asset
turnover, and higher debt
II. A firm’s sustainable growth rate can be estimated by multiplying the earnings
retention ratio by the return on equity.
A) I is correct, II is incorrect
B) II is incorrect, II is correct
C) I and II are both incorrect
D) I and II are both correct

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 Multiple Choice: answer on the GREEN computer answer sheet

7. You have observed that every time the Andrews Sisters Music Corp’s stock rises for three days in a
row you cannot predict what stock price will do on the 4th day. This observation is consistent with:
A) Strong form market efficiency
B) Semi-strong form market efficiency
C) Weak form market efficiency
D) The observation is not consistent with any form of market efficiency.

8. You have received the following information about two bank accounts:

Year Account 1 Account 2

1 125 125
2 127 125
3 130 125
4 133 125
Assuming that you did not deposit or withdraw any money from the accounts, then:

A) Both accounts pay simple interest

B) Both accounts pay compound interest
C) Account 1 pays simple interest while account 2 pays compound interest
D) Account 1 pays compound interest while account 2 pays simple interest

9. Which of the following is NOT a true statement of the Net Present Value (NPV) analysis?
A) The NPV of a project is the sum of the present value of all future after-tax incremental cash
flows generated by an initial cash outlay, minus the present value of the investment outlays.
B) Projects that have a positive NPV should be accepted, and projects that have a negative NPV
should be rejected.
C) The NPV is the present value of the expected cash flows net of the costs needed to generate
them.
D) The firm’s after-tax marginal cost of capital is the appropriate discount rate for all projects.

10. The M&M proof of capital structure irrelevance relies on:

A) Arbitrage arguments
B) Personal and corporate leverage are perfect substitutes
C) All of the above
D) None of the above

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 Multiple Choice: answer on the GREEN computer answer sheet

B. Calculation Multiple Choice Problems (15 Questions, 3 Points Each)

11. Charlie purchased 3 shares of AIG one year ago for $50 per share. Today, he received a dividend
of $2.50 per share and sold the shares at $5 per share. His annual rate of return is closest to:
A) 15%
B) 10%
C) -85%
D) -90%

= ( 5 + 2.50 -50 ) / 50 = -85%

12. Amr has $50,000 to invest and has decided to invest $10,000 in the stock of ABC and the rest in
YUL. The standard deviation of the returns of ABC is 8% while the standard deviation for YUL is
14%. He is happy to see that the correlation between the two stocks is negative and is -.15. The
standard deviation of the portfolio is closest to:
A) 11.07%
B) 11.19%
C) 11.31%
D) 11.55%
E) Cannot be determined, we need the covariance between the two stocks.

Weight in ABC = 10/50 = 20%

13. Ignatius Loyola planning on investing $500 per year, starting immediately, for the next 10 years.
He expects to earn a rate of return of 8% compounded annually on the investment. The value of his
investment at the end of the 10th year will be closest to:
A) $3,355.04
B) $3,623.44
C) $7,243.28
D) $7,822.74

FV of an annuity due.

14. The UGY Company has just paid a dividend of $15. Their dividends are expected to decrease by
3% per year forever. The required rate of return for UGY is 5%. The current stock price of UGY is
closest to:
A) $772.50
B) $750.00
C) $187.50
D) $181.88

D0 (1 + g ) 15 (1 − .03)
= = = $181.875
r−g .05 + .03

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 Multiple Choice: answer on the GREEN computer answer sheet

15. The GRG Company has a beta of .85. The risk free rate is 2% and the expected return on the
market is 7%. The required rate of return on GRG stock is closest to:
A) 6.20%
B) 5.00%
C) 4.25%
D) 2.00%

2% + .84 *( 7% - 2% ) = 6.2%

16. Franklin wishes to have $10 million in his retirement savings plan in 25 years. His bank is offering
him an investment that promises a return of 8% compounded semi-annually. Franklin wishes to
deposit money every month. Franklin’s monthly deposit is closest to:
A) $33,333
B) $11,001
C) $10,740
D) $10,515

Effective monthly rate: (1 + .08 / 2 ) 6 − 1 = 0.65582%

1

Future value = $10 million, number of payments = 25 * 12.

17. A project requires an initial cash outlay of $16,000 and provides cash flows of $4,500 in year 1,
$5,500 in year 2, $6,500 in year 3, and $7,500 in year 4. Assume the appropriate discount rate is
10 percent. The payback period is closest to:
A) 2.08 years
B) 2.36 years
C) 2.68 years
D) 2.92 years
E) 3.48 years

18. The Excello Company currently has no debt in its capital structure. Their current cost of capital is
8%. The firm expects to earn a perpetual EBIT of $15,000 per year. The managers have decided to
change the capital structure of the firm by issuing $30,000 of risk free debt to repurchase stock.
The cost of debt to the firm is 5%. The firm operates in a world with no taxes. Assume all the
M&M assumptions are satisfied. The value of the firm after this change will be closest to:
A) $187,500
B) $198,750
C) $217,500
D) $250,000
E) Cannot be determined, we need the levered cost of equity

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 Multiple Choice: answer on the GREEN computer answer sheet

19. The Lunar Rover Company is considering buying a new machine and has spent $25,000 evaluating
the different alternatives. The preferred new machine will cost $500,000 and will result in an
increase in operating cash flows of $230,000 per year for the next 3 years. At the end of the 3
years, the machine will have a zero salvage value. The machine is in a class with a CCA rate of
25%. The company has many machines in that class and expects to continue to have many
machines in the class in 3 years. The acquisition of the machine will not require any changes to net
working capital. The company has a marginal tax rate of 35% and the appropriate discount rate is
8%. The NPV of the investment is closest to:
A) -$114,724
B) -$16,748
C) -$12,059
D) $12,941

PV of initial investment and annual operating cash flows (after tax) = -114,724 (note $25,000 is sunk
cost)

PV of CCA benefits =( (500*.25*.35/(.25+.08))*((1+.5*.08)/(1.08))

=(43.75/.33)*(0.96296)
= $127,665.54

Total NPV = $12,941

20. The ABC Company needs to raise $10 million in common equity. If they can issue stock at $25 per
share and have flotation costs of equity of 8%, then the number of common shares the company
will need to issue is closest to:
A) 370,000
B) 400,000
C) 432,000
D) 435,000

21. The ABC Company operates in a world with zero taxes and no financial distress. The firm has a
debt/equity ratio of 3. The cost of equity to ABC is 14% and the cost of debt is 5%. The only
difference between ABC and the DEF Company is that DEF has no debt. The cost of equity for
DEF is closest to:
A) 5%
B) 7.25%
C) 9.5%
D) 14%

WACC of levered firm = ( 3 * 5% + 1 * 14% ) /4 = cost of equity of unlevered (in this world)

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 Multiple Choice: answer on the GREEN computer answer sheet

22. Nicola has just finished plotting the relationship between the NPV of two mutually exclusive
projects (MiniHospital and SuperHospital) for different discount rates.

200

150
Project NPV $'000

100

50

0
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11%
-50

-100

-150
Discount rate

MiniHospital SuperHospital

Based on the above plot, Nicola should:

A) Choose the SuperHospital project as its IRR is greater than the MiniHospital project
B) Choose the MiniHospital project as its IRR is greater than the SuperHospital project
C) If the opportunity cost is greater than 5%, choose the MiniHospital project. If the discount rate
is less than 5%, choose the SuperHospital Project
D) If the opportunity cost is greater than 5%, choose the SuperHospital project. If the discount rate
is less than 5%, choose the MiniHospital Project
E) Cannot make a recommendation because the NPV profiles cross

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 Multiple Choice: answer on the GREEN computer answer sheet

Questions 23 to 25 use the following information:

The ABC Company currently has a perpetual EBIT of $475,000 and pays taxes at a rate of 35%. ABC
has a D/E ratio of 2 and has debt of $2.5 million outstanding. The debt is perpetual and risk free with
an interest rate of 5%.

23. The current value of ABC is closest to:

A) $2.5 million
B) $3.75 million
C) $7.5 million
D) $10 million

D/E = 2 Æ D = 2 * E Æ E = ½ D Æ total value = D + E = 1.5 * D

24. The weighted average cost of capital for ABC is closest to:
A) 3.25%
B) 5%
C) 8.2%
D) 12.35%

EIBT(1-t)/MV = 475 * .65 / 3750

25. ABC is planning on issuing $1 million of new risk free debt and using the proceeds to repurchase
stock. The change in value of ABC is closest to:
A) Increase of $350,000
B) Decrease of $350,000
C) No change in value

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 Problems: Answer on the exam in the space provided

Problem 1. (10 marks) The Excalibur Sword Company is considering introducing a new product – the
Light Sabre. The company has spent $10 million on research and development and expects to
spend $5 million per year for the next 5 years before the Light Sabre can enter the market. In 5
years, Light Sabre will be launched and expected to earn $3 million in profits at the end of year 6
and Light Sabre profits are expected to grow at a rate of 3% per year forever.

Currently, Excalibur sells a basic plastic sword which earns an annual profit of $5 million per year.
Once the Light Sabre hits the market, the sales of the plastic sword are expected to decline by 2.5%
per year forever.

Assume that Excalibur pays no taxes, all cash flows are at the end of the year and the appropriate
discount rate for both products is 10%.

Do you recommend that Excalibur introduce the Light Sabre? Support your recommendation with
any necessary calculations. Show your work clearly in order to obtain part marks –
recommendations without support will receive a zero.

$10 million already spent of R&D is sunk cost – not relevant for current decision.
PV of plastic swords: 5/.1 = $50 million

PV of additional R&D = 5 year ordinary annuity = $18.59 million

PV at year 5 of additional Light Sabre profits = 3 / (.1 - .03) = $42.8571
PV today = $26.61 million

PV of plastic sword (no Light Sabre) at year 5 = $50 million

PV of plastic sword at year 5 = 5 / (.1 + .025) = $40 million
- loss in plastic sword due to Light Sabre = (50 – 40) discounted back to today
- = 6.21 million
PV of 5 years of plastic sword sales: 5 year annuity = $18.95 million

Incremental value of Light Sabre: (R&D + Light Sabre sales – lost Plastic Sword sales + 5 years of
Plastic Sword sales) – value of no Light Sabre introduction = (-18.59 +26.61-6.21+18.95)-50 = -$29.24
million

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 Problems: Answer on the exam in the space provided

Recommendation:

Do not introduce the Light Sabre,

incremental value is negative.

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 Problems: Answer on the exam in the space provided

Problem 2. (8 marks) A company must choose between two new computer systems: Alpha and Bravo,
to replace the existing system to support its ongoing operations. System Alpha costs $50,000 and
will result in savings of $19,000 per year during its four-year life. System Bravo costs $75,000 and
will result in savings of $15,000 per year during its nine-year life. The appropriate discount rate is
8 percent. Which system should the firm choose and why? Show your work!! Assume both
systems can be replicated indefinitely and there are no taxes.

NPV Alpha = $12,930.41

Need EANPV (different lives) --- EANPV alpha = $3,903.96

NPV Bravo = $18,703.32

EANPV Bravo = $2,994.02

Choose Alpha Higher EANPV

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 Problems: Answer on the exam in the space provided

Recommendation:

Choose Alpha Higher EANPV

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 Problems: Answer on the exam in the space provided

Problem 3. (4 marks) Jiang Min has obtained the following information on the Velocity Bicycle
Company:
- book values: assets = $250,000; common equity = $25,000; preferred stock = $150,000 and
debt = $75,000. Coupons on debt are paid once a year.
- number of shares outstanding: 10,000 common and 25,000 preferred
- market prices per share: common stock $25, preferred $10
- preferred dividend $1.00 per share; coupon rate on debt is 8%; Velocity does not pay
dividends on its common stock
- beta of the stock is 1.25
- yield to maturity of debt is equal to the coupon rate
- tax rate is 35%, risk free rate is 2%, expected return on the market is 15%.

Calculate the weighted average cost of capital (WACC) or the Velocity Bicycle Company. Show your
work clearly. If the answer cannot be determined using the available information, explain what
information is missing and how you would use it.

Common stock: value = 10,000 * $25 = $250,000

Cost of equity = 2% + 1.25 * (15 – 2) = 18.25%

Preferred stock: value = 25,000 * $10 = $250,000

Cost of preferred = $1/$10 = 10%

Debt: value = $75,000 (coupon = yield Æ price = face)

Yield (before tax) = 8%

WACC = (1/575) * (250*18.25% + 250*10% + 75 * 8% * (1-.35)) = (1/575) * 7452.5 = 12.96%

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 Problems: Answer on the exam in the space provided

WACC = 12.96%

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 Problems: Answer on the exam in the space provided

Problem 4. (4 marks) Your grandfather is very confused – he understands that a higher expected return
is associated with higher risk. However, he has observed that two firms (Alpha and Omega) have
the same expected return; however, the standard deviation of Alpha is much higher than the
standard deviation of Omega. In a world that satisfies the CAPM assumptions, is this possible?
Briefly explain your reasoning.

____________Total risk = systematic + unsystematic. CAPM Æ only reward for holding systematic

(can’t be diversified away). Grandfather is mixing total (standard deviation) with

systematic._________________________________________________________________________

__________________________________________________________________________________

__________________________________________________________________________________

__________________________________________________________________________________

_______________________________________________________________________________

Problem 5. (4 marks) Your boss, a McGill MBA graduate, is very confused about capital budgeting
and the CCA. He understands that the analysis should focus on cash flows and non-cash expenses
should not be considered. Your boss believes that the CCA should not be incorporated in a capital
budgeting analysis as it is not a cash expense. Do you agree or disagree? Briefly explain your
reasoning.

__Disagree – CCA is important because it gives us a tax deduction which is a cash savings

__________________________________________________________________________________

__________________________________________________________________________________

__________________________________________________________________________________

_________________________________________________________________________________

HAVE YOU:
- Put your Name and ID on the exam, computer answer sheet and “crib” sheet?
- Make sure you hand in the exam, the computer answer sheet and “crib” sheet.

--- Have a great holiday and see you in the new year ---

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