FNCE 20005 Corporate Financial Decision Making

Mid-Semester Test (MST) Announcement

(1) When? Lecture times in Week 6

 Wednesday April 10
 Thursday April 11
 Please go to the test during the lecture time that you are formally enrolled in. The
test will go for one hour (no reading time)

(2) Where?
 Locations, seating lists, and exam starting times will be released on Canvas (LMS)

(3) What is the format?

 20 multiple choice questions – each with 5 options
 A mixture of quantitative and qualitative questions – bring your calculator as there
won’t be any spares. Effective from 1 January 2017, the approved calculator for
all subjects is the Casio FX82 (any suffix). No equivalent models of calculators
will be permitted in exams.

(4) What is examinable?

 The first four weeks of lectures (approximately equally)

(5) Scaling will be employed if there is a significant difference in average marks across the two
streams

(6) Any advice?

 For each question, choose the option that is closest to your own answer.
 Check the practice test including the front-page & formula sheet. The actual test
includes an identical formula sheet.
 Understand the content (not simply memorize without thinking)
o Primary source of study: lecture notes, practice test, tutorial material
o Secondary source of study: Textbook & reading materials (only the parts
related to the lecture notes)

(7) Alternative Examination Arrangements (AEA) and Special consideration:

For important and relevant information about AEA and Special Consideration please refer to
the detailed announcement on the LMS (posted Monday February 26, 2024).

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 Student Number:
Seat Number:

THE UNIVERSITY OF MELBOURNE

DEPARTMENT OF FINANCE

PRACTICE TEST
SUBJECT NUMBER: FNCE 20005
SUBJECT NAME: Corporate Financial Decision Making
EXAMINATION DURATION: 1 hour
READING TIME: None
TOTAL MARKS: 20
NO. OF PAGES: xxx
(Do NOT write your name anywhere on this exam booklet)
AUTHORISED MATERIALS
1. This is a CLOSED BOOK examination.
2. Only Casio FX82 (any suffix) calculators are permitted. No other models of calculators
will be permitted in the exam.
3. Students are NOT permitted to use any dictionary.
INSTRUCTIONS TO INVIGILATORS
1. Students should be provided ONLY with this booklet and an M1 Multiple Choice Answer
Sheet.
2. Writing is NOT permitted during reading time.
3. This booklet must be COLLECTED at the end of the examination.
INSTRUCTIONS TO STUDENTS
1. Writing is NOT permitted during reading time. (if applicable)
2. Once writing is permitted, write your seat number and student number in the boxes at the
top of this cover page.
3. Complete the M1 Multiple Choice Answer Sheet as follows:
 Write your subject code and surname in the boxes provided on the sheet.
 Write your Student Number under the words Student Number and then colour in the corresponding
circles beneath the number. Do not put zeros at the beginning of the student ID on the multiple choice
form. Begin with the first digit of your student ID.
4. Answer ALL questions. Record your answers to Part A on the M1 Multiple Choice Answer
Sheet. Answers recorded in any other space will not be marked.
5. Pages titled “THIS PAGE HAS BEEN LEFT INTENTIONALLY BLANK” are provided
for rough work. Examiners will NOT take into account anything written on these pages.
6. A formula list is provided on the last page. You may detach this page.
7. Do NOT detach any other pages.
8. This paper must be handed in at the end of the examination. Do NOT remove this
paper from the examination room.
BAILLIEU LIBRARY
1. This paper may NOT be lodged with the library.
This paper MUST NOT be lodged with the Baillieu Library AT ANY TIME.
Examiners Use Only
Marks Total Questions Required
Multiple 20 20 Attempt ALL questions
Choice
Total 20 20 Attempt ALL questions

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 ANSWER ALL QUESTIONS
 All answers should be answered on the scan sheet (M1): Questions 1-20.
 You are to fill in all the relevant student information as well as write your name
and student number on the scan sheet. For the scan sheet, you are to make sure
that it is filled in legibly.
 Only mark one answer per question. There is only one right answer per question.
Choose the best and most complete answer to the question which is asked.

Question 1

Which of the following statements accurately describes the association between “information
asymmetry” and IPO pricing?

a) This hypothesis suggests that IPOs are underpriced, on average, to help reduce the
information asymmetry between managers and investors.
b) It suggests that the primary motivation for underpricing an IPO is to retain informed
investors in the IPO market.
c) It suggests that the issuing company has the incentive to underprice an IPO to benefit
the existing (original) shareholders prior to firm listing on the exchange.
d) None of the other statements accurately describes the association between
“information asymmetry” and IPO pricing.
e) More than one of other statements accurately describes the association between
“information asymmetry” and IPO pricing.

Question 2

A company floats on the stock exchange. At the end of first day’s trading its closing price is
$5 per share. Upon observing this outcome, the financial press notes that its subscription
price was too high (or it was overpriced) by 15%. Which of the following is the closest to the
subscription price of this IPO (use the same technique as covered in class)?

(a) $5.75
(b) $5.90
(c) $4.25
(d) $5.88
(e) $4.85

Question 3

Which of the following statements accurately describe the reasons for long-run
underperformance of IPOs?

a) Companies are commonly sued soon after listing (for misstatements) and the
significant costs associated with these lawsuits results in underperformance
b) Managements make use of “windows of opportunity” to list their companies and
subsequent decline in demand for equity results in underperformance
c) Typically, only pessimistic investors invest in IPOs and as their pessimism tends to
increase in the long-run, the companies exhibit underperformance
d) More than one of the other statements is correct
e) None of the other statements is correct
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Question 4

XYZ Limited’s current share price (cum rights) is $10 per share. XYZ makes a two for seven
rights issue with the subscription price of $2 per share. Which of the following is closest to
the value of the right to buy one new share in XYZ (do not consider other pricing factors)?

a) $1.00
b) $2.50
c) $6.22
d) $3.11
e) $8.00

Question 5

Assume that a company announced a rights offer. Which of the following statements
correctly describes the characteristics associated with the rights offer made by this company?

a) The observed ex-rights price might be higher than the theoretical ex-right price.
b) The theoretical value of right to buy a new share typically incorporates the value of
the option associated with the right
c) The theoretical ex-right price is only ever related to the subscription price.
d) More than one of the other statements is correct
e) None of the other statements is correct

Question 6

Which of the following statements accurately describes a valid reason why firms may prefer
returning cash via buyback instead of dividends?

(a) Unlike dividends, a buyback creates an expectation by shareholders that the firm will
continue to distribute cash via buyback in the subsequent periods.
(b) Unlike dividends, a buyback can be used to as a tool to control the inherent volatility
of a company’s operating cash flows.
(c) Unlike dividends, a buyback can be used to signal that the mangers believe the
company is undervalued by the market.
(d) More than one of the other statements accurately describes a valid reason why firms
may prefer returning cash via buyback instead of dividends.
(e) None of the other statements accurately describes a valid reason why firms may prefer
returning cash via buyback instead of dividends.

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Question 7

ABC Inc., an Australian firm paying a corporate tax rate of 28%, announced a fully franked
cash dividend of $4.32 per share with the ex-dividend date of 5th April 2022. Paul purchased
1000 shares in ABC on 1st January 2022 and is eligible to receive the dividends. If Paul’s
personal tax rate on dividend is 35%, which of the following is closest to the tax payment that
Paul has to make on his dividend income?

a) $420.0
b) $168.0
c) $1512.0
d) $604.8
e) $1,209.6

Question 8

Which of the following statements accurately describe the reason(s) why dividend policy is
important?

a) Paying dividends increases firm value because shareholders bear less risk by
receiving dividends instead of selling shares to realize capital gains.
b) Increase in dividends is normally used to signal the market that the mangers believe
the company has poor prospects in the foreseeable future
c) Under imputation tax system, firms should pay as much franked dividends as possible
because shareholders always prefer franked dividends over capital gains.
d) More than one of the other statements accurately describe a reason(s) why dividend
policy is important.
e) None of the other statements accurately describe a reason(s) why dividend policy is
important.

Question 9

Unicorn Inc. is an Australian listed firm that pays corporate tax rate of 30%. Unicorn recently
conducted an off-market share buyback under tax determination TD2004/22. On 10th March
2022, Unicorn announces the buyback price to be $18.40 per share with a fully franked
dividend of $13.50. The buyback closed on 5th April and Unicorn’s relevant 5-day VWAP
was $18.85. The general market also decreased by 0.5% over the relevant time period.

Alan Smith is an Australian resident for tax purpose with a marginal tax rate of 45%. He sold
800 Unicorn shares (purchased at $10.25 per share on 21st February 2020) into the buyback.
Which of the following is closest to his after-tax proceeds from the capital component of his
sale?

a) $4,818.97
b) $4,774.19
c) $4,655.18
d) $4,515.86
e) $3960.00

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Question 10

Which of the following statements accurately describes the buyback behaviour of Australian
companies?

a) Off-market buybacks are more likely to be used when the company is generating
more cash flows
b) On-market buybacks are more likely to be used when managers wish to distribute
franking credits
c) Off-market buybacks are more likely to be used when the company is undervalued
d) More than one of the other statements is correct.
e) None of the other statements is correct.

Question 11

Which of the following tends to be a (the) characteristic(s) of a finance lease?

a) The lessee is usually the owner of the asset.

b) The risks of ownership tend to be borne by the lessor.
c) The lease contract is cancellable by the lessee without substantial penalty.
d) More than one of the other statements are the characteristics of a finance lease.
e) None of the other statements are the characteristics of a finance lease.

Question 12

Which of the following statements accurately describe the reason(s) why leasing may be
advantageous for both the lessor and the lessee?

a) Simpler liquidation process allows the lessor to share the associated benefits with lessee
by charging a higher lease payment.
b) Differences in company taxation rates may allow lessor to charge a lower lease payment
from the lessee
c) Higher cost of capital allows the lessor to share the associated benefits with the lessee.
d) More than one of the other statements accurately describe the reason why leasing may
be advantageous for both the lessor and the lessee.
e) None of the other statements accurately describe the reason why leasing may be
advantageous for both the lessor and the lessee.

Question 13

Which of the following statements accurately describes the characteristics associated with
covenants that may be included in a debt contract?

a) Covenants are imposed to protect the interests of equity holders.

b) Covenants cannot impose a dollar limit on a company’s plans to undertake capital
expenditures
c) Only negative covenants can be imposed on a company by its debt holders
d) More than one of the other statements accurately describe the characteristics associated
with covenants that may be included in a debt contract.
e) None of the other statements accurately describe the characteristics associated with
covenants that may be included in a debt contract.
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Question 14

Queens Limited, a sofa manufacturer, is looking to acquire new equipment for the production
of a new product line, which has a required rate of return of 15% per annum. Queens can
borrow at 12% per annum and buy the equipment outright for $800,000. The equipment has
an expected life of 6 years and Queens will dispose the equipment after 6 years with an
expected salvage value of $100,000. Alternatively, Queens can lease the equipment from
Moe’s Leasing for $150,000 p.a. for 6 years with premiums payable in advance. The
applicable corporate tax rate is 30% and the equipment will be fully depreciated using a
straight-line method over its expected life. When evaluating this finance lease, which of the
following statements accurately describes a relevant cashflow at the end of year 6 (using the
approach covered in lectures)?

a) $150,000 should be subtracted at the end of year 6 for the lease payment.
b) $30,000 should be subtracted at the end of year 6 because of the tax payment on the
gain from sale.
c) $100,000 should be subtracted at the end of year 6 because of no proceeds are
received from sale.
d) None of the other statements accurately describes a relevant cashflows at the end of
year 6 on the evaluation of finance lease.
e) More than one of the other statements accurately describes a relevant cashflow at the
end of year 6 on the evaluation of finance lease.

Question 15

Which of the following statements is correct in relation to hybrid securities?

a) Convertible notes tend to have a higher interest rate than debt because they may be
converted to equity in the future.
b) Preference shareholders typically receive dividends before payments have been made
to the debtholders.
c) Convertibles allow companies to overcome the negative signal associated with issuing
ordinary shares.
d) None of the other statements is correct in relation to hybrid securities.
e) More than one of other statement is correct in relation to hybrid securities.

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Question 16

Tesla Inc, a U.S. company, is considering changing its capital structure. The company has
debt and equity in its capital structure and the current D/E ratio is 0.6, the current weighted
average cost of capital of Tesla is 11.04% p.a. The current before-tax cost of debt capital for
Tesla is 10% p.a., the current cost of equity is 13.47% p.a. and current equity beta is 1.21.
The risk-free rate and market risk premium are 5% p.a. and 7% p.a. respectively. The
corporate tax rate is 30%. If the company switches to a capital structure with 100% equity,
which of the following is closest to the new weighted average cost of capital of Tesla Inc
(using the approach covered in the lecture)?

a) 10.96% p.a.
b) 12.17% p.a.
c) 7.00% p.a.
d) 7.42% p.a.
e) 11.04% p.a.

Question 17

Which of the following statements accurately describes features of the trade-off theory of
capital structure?

a) The theory suggests that companies’ debt issuance decisions are based on the trade-
off between tax benefits associated with debt and costs associated with information
asymmetry between firms and investors.
b) The theory suggests that when leverage rises above the target level, a firm should buy
back stock in order to reduce the level of debt in its capital structure.
c) The theory suggests that firms tend to maximize the cost of capital by balancing the
tax shield benefits generated by debt and financial distress costs.
d) None of the other statements accurately describes features of the trade-off theory of
capital structure.
e) More than one of the other statements accurately describes features of the trade-off
theory of capital structure.

Question 18

Which of the following statements accurately describe the effect of leverage on a company’s
shareholders?

a) Shareholders’ voting rights in the company change as the company’s leverage

changes
b) Increase in leverage increases the financial risk shareholders are exposed to as a
higher proportion of company’s cash flows are distributed to the debtholders.
c) Increase in leverage increases the business risk shareholders are exposed to as
company’s debtholders force the company to adopt a more aggressive business
strategy
d) More than one of the other statements is correct
e) None of the other statements is correct

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Question 19

Which of the following statements is correct regarding the weighted average cost of
capital (WACC) of a firm?

a) When using WACC as the required rate of return for new projects, a
conglomerate (multi-division) firm will tend to accept riskier projects and
reject safer ones.
b) WACC is calculated by averaging the cost of a firm’s capital, including debt
securities, ordinary shares, etc., weighted by their respective book values.
c) WACC should only ever be used to value the entire firm, and never used to
value individual projects.
d) More than one of the other statements is correct regarding the weighted
average cost of capital (WACC) of a firm.
e) None of the other statements is correct regarding the weighted average cost of
capital (WACC) of a firm.

Question 20

Simple Tech Inc is an Australian company operating in a pure imputation tax system. It is
currently financed entirely (100%) by equity and has a beta of 0.8. After examining its capital
structure, Simple Tech finds that the optimal capital structure can be achieved at D/E ratio of
0.4. The before-tax cost of debt capital for Simple Tech at the optimal capital structure is
10% p.a. The risk-free rate and market risk premium are 5% p.a. and 7% p.a., respectively. If
the statutory corporate tax rate is 30%, which of the following is closest to the cost of equity
at the optimal capital structure (using the approach covered in the lecture)?

a) 12.84% p.a.
b) 12.17% p.a.
c) 12.03% p.a.
d) 11.69% p.a.
e) 10.60% p.a.

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 Formula Sheet

∗ +
=
+1

Dividend Drop-off Ratio = ( − )/Dividend

− 1−
=
. 1−

! "
=
1−

Franking credits = ×

0123 345
0 =
67892 :; ℎ1295

D E
WACC  k   kd 1  te     ke  
V  V 
= =1 − >?

@ = AB + C [0=A ? − AB ]

Q
F =
@ −4

F =1 + 4?
@ = +4
F

O KIL : I 27
G1H69 :; I 27 = J
LPQ =1 + MNKK?
L

CR = C S1 + =1 − ? T = C + C =1 − ?
0 0

GR = G + G= 3 9295 1U 5ℎ 9HV5? = G +

GR = G + − G=9UW. V 5 2955 X:5 5?

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