Financial Management Multiple Choice and long answers
Instructions: – There are a total of 11 pages.
– Please submit all answers in a single “Word” or “PDF” document with your name and student number on each page.
– The multiple choice questions in Section/Question One are either correct or incorrect (i.e. there are no part marks). Please simply provide the correct letter of the alphabet per question. Part marks will be awarded for the long answer questions (Sections/Questions II. – VII.) so clearly state any assumptions that you feel are necessary for these.
– You may “cut and paste” from excel into your word/pdf document if you like but please make sure the formatting is clear.
Section / Question Possible Marks
Question I: Multiple Choice (2 marks each X 26 questions for a total of 52 marks)
Choose the alternative that BEST answers each of the following questions.
1. Which of the below is the most important determinant of how many years into the future you should project a company’s cash flows when doing a discounted cash flow analysis?:
A) A company’s tax rate.
B) A company’s cost of debt.
C) The growth rate of the company’s projections.
D) The expected capital expenditures of a company.
2. What is the difference between a Primary Market and a Secondary Market in the context of stock markets?
A) A Primary Market is the major exchange in a country and the Secondary Market is the “growth” exchange (i.e. NYSE vs. NASDAQ).
B) A Primary Market involves the issue of new securities and the Secondary Market involves the trading of existing securities.
C) A Primary Market is the main market that investors trade in (i.e. NYSE) and the Secondary Market is otherwise known as the Over The Counter, or “OTC”, market.
D) A Primary Market is a large stock market, such as the NYSE, and a Secondary Market is a relatively small stock market, such as the TSX.
3. A mother sets aside $10,000 in an account for her newly-born daughter with the intention of funding her college education in 18 years. The mother expects that the market interest rate will be 5% for the first 10 years, but that it will climb to 10% for the following 8 years. How much will the daughter have as she enters college in 18 years?
4. Matthew just purchased a house for $250,000. His down payment is $70,000 and the remaining amount will be financed using a 20-year mortgage. The interest rate on this mortgage is 5.6% compounded semi-annually and Matthew will make monthly mortgage payments. How much will the monthly payments be?
5. You plan to borrow $1,000 and repay it with five equal annual payments at an interest rate of 12%. You have a choice of making the payments at the end of each period, or at the beginning of each period. If you choose to make the payments at the beginning of each period rather than at the end, how much smaller will the payments be?
6. You are considering creating a portfolio with 100 securities which are equally weighted. Which of the following statements is the most true when determining the risk of your portfolio?
A) The sum of the risks of the individual securities is the most important factor.
B) The weighted average expected returns of the portfolio is the most important factor.
C) The covariance of the securities with each other is the most important factor.
D) The portfolio’s efficient frontier is the most important factor.
7. Which of the following are considered to be cons of granting stock options to senior executives?
They give extra incentive to manipulate accounting information.
II. They can encourage excessive risk taking.
III. They provide a tax break via delayed taxation.
IV. They reward executives inappropriately during a stock market boom.
A) I and IV only.
B) I, II and IV only.
C) I, II, III and IV.
D) I, II and III only.
8. Sarah has invested $10,000 in a savings account with a Quoted Rate of 3% and monthly compounding. At the end of 16 months how much will be in Sarah’s account if she makes no deposits or withdrawals during that time?
9. You’ve just won a minor lottery. You have two options: option 1 is to receive $700,000 today and option 2 is to receive $100,000 at the end of every year for 10 years beginning at the end of 2 years from now. Assuming that you can earn 6% on his money, what should you do and why?
A) Take option 1 because you earn $36,008.71 more in today’s dollar terms this way.
B) Take option 1 because you earn $5,652.16 more in today’s dollar terms this way.
C) Take option 2 because you earn $36,008.71 more in today’s dollar terms this way.
D) Take option 2 because you earn $5,652.16 more in today’s dollar terms this way.
10. Which of the following statements best describe the fundamental difference between a Dividend Discount Model approach to valuing stocks and a P/E approach to valuing stocks?
A) The P/E approach is best because it shows how a stock is priced given the credit rating of the company.
B) The Dividend Discount Model illustrates the future value of the dividend cash flows and the P/E approach illustrates what a company’s sales are actually worth.
C) Neither of these approaches are used by serious investors – the best method is the Behavioral Finance approach.
D) The Dividend Discount Model is an intrinsic valuation approach whereas the P/E approach is a relative valuation approach.
11. Which of the following will decrease the required return on a bond?
II. Conversion feature.
III. Cross default clause.
IV. Negative pledge clause.
A) I, III and IV only.
B) I, II and IV only.
C) IV only.
D) All of the above.
12. Which one of the following would most likely have the strongest impact on the results of a discounted cash flow analysis for a risky, early stage technology company?:
A) Whether the “full year” or the “half year” discounting convention is used.
B) The pre-tax cost of the company’s debt.
C) The company’s tax rate.
D) Whether the arithmetic mean or the geometric mean was used in determining the equity market risk premium.
13. If the correlation between two stocks is +1, then a portfolio combining these two stocks will have a standard deviation that is:
A) Less than the weighted average of the two individual standard deviations.
B) Greater than the weighted average of the two individual standard deviations.
C) Equal to the weighted average of the two individual standard deviations.
D) Less than or equal to average standard deviations of the two weighted standard deviations, depending on other information.
14. What is the method most widely used by serious finance professionals to calculate a company’s cost of equity?
A) Bond yield plus risk premium.
B) Capital asset pricing model.
C) Dividend discount model.
D) Multi-factor asset models.
15. Within the context of the Capital Asset Pricing Model (CAPM), assume:
Market risk premium = 4.5%
Current risk free rate = 2%
Historical average of the equity market return = 11%
Beta of security = 2.25
Additional Country Risk Premium = 1.0%
What would most likely be the cost of equity of this security?
16. Which of the following does not support the idea of “Behavioural Finance”?:
A) Speculative bubbles.
B) “Flash” crashes.
C) Increased market efficiency due to greater transparency.
D) Inside information.
17. Which of the following proportions of cash, bonds and stocks best describes an aggressive investor?
A) Cash: 10%, Bonds: 0%, Stocks: 90%.
B) Cash: 0%, Bonds: 90%, Stocks: 10%.
C) Cash: 15%, Bonds: 40%, Stocks: 45%.
D) Cash: 20%, Bonds: 20%, Stocks: 60%.
18. Which of the below characteristics best describes a bond with the best credit rating?
A) High interest coverage ratio, low leverage (i.e. Debt/EBITDA) ratio.
B) High interest coverage ratio, high leverage (i.e. Debt/EBITDA) ratio.
C) Low interest coverage ratio, low leverage (i.e. Debt/EBITDA) ratio.
D) Low interest coverage ratio, high leverage (i.e. Debt/EBITDA) ratio.
19. A simple zero-coupon bond:
A) Sometimes sells at a price below par and sometimes sells at a price above par (depending on interest rate movements).
B) Always sells at a price below par before maturity.
C) Always sells at a price above par before maturity.
D) Famously has no maturity.
20. You have won a strange lottery that gives you a few different possible payment options from which you can choose. Given a market interest rate of 5% compounded annually, which of the following gives you the greatest payoff?:
A) A single payment of $70,000 received in 2 years.
B) $5,000 each year for 15 years – starting one year from now.
C) A single payment of $50,000 received today.
D) A growing perpetuity that gives you $2,000 next year and grows at 1.5% forever.
21. In the context of a publicly traded comparable company analysis, which of the following would not be appropriate in the denominator to calculate a multiple using equity value in the numerator?
C) Net Income.
D) Book value.
22. What is the implied stock price for a company that is expecting to make $4.00 per share in earnings next year, has a cost of equity of 8%, a WACC of 9.5%, a retention rate of 50% and a return on equity of 13%?
Use the following information to answer Question 23 and Question 24.
Goosebury Construction’s stock has an expected return (or “cost of equity”) of 12%. Government debt is currently trading at a yield of 1.9%. In Goosebury Construction’s country, the yield on government debt has historically been 6.1% over the last 50 years, calculated using the arithmetic mean, and 5.3%, calculated using the geometric mean. In Goosebury Construction’s country’s stock market, the historical return has been 11.1% over the last 50 years, calculated using the arithmetic mean, and 9.4%, calculated using the geometric mean.
All else being equal, if Goosebury Construction’s beta with the market triples, what should the new expected return (or “cost of equity”) of Goosebury Construction be? Please calculate this twice, firstly using the geometric mean data to calculate the equity market risk premium (Question 23) and then using the arithmetic mean data to calculate the equity market risk premium (Question 24).
23. Using the geometric mean data to calculate the equity market risk premium, Goosebury Construction’s new expected return (or “cost of equity”) would be:
D) None of the above.
24. Using the arithmetic mean data to calculate the equity market risk premium, Goosebury Construction’s new expected return (or “cost of equity”) would be:
D) None of the above.
25. What is the best source of the weights that are used for the weighted average cost of capital?
A) The balance sheet.
B) The Capital Asset Pricing Model.
C) The stock market.
D) Market values.
26. When performing a discounted cash flow analysis to calculate a firm’s enterprise value, the best way to value the “terminal value” is by using:
A) EBITDA multiples.
B) EBIT multiples.
C) The perpetuity growth rate of the firm’s levered free cash flows (and comparing the implied PE multiples of this result to the firm’s current PE multiples as a sanity check, or vice versa).
D) The perpetuity growth rate of the firm’s unlevered free cash flows (and comparing the implied EBITDA multiples of this result to the firm’s current EBITDA multiples as a sanity check, or vice versa).
Questions II. – VII.: Long Answer Questions (48 Marks)
Question II (8 Marks)
A financial engineer designs a new financial instrument that he calls, the Lorax. This instrument gives the holder access to the following cashflows:
• For the first 7 years, the holder receives $100 per year starting one year from today (a total of 7 payments).
• The holder does not receive any cashflows for years 8 or 9.
• Starting at the end of year 10, the holder receives $75 growing at a rate of 9% per year forever.
• The holder has to pay a “service fee” of $15 every year starting at the end of year 2; this goes on forever.
The prevailing discount rate throughout is 10%. The financial engineer would like to determine a fair market price for this financial instrument. What do you suggest this price to be? (8 Marks)
Question III. (3 Marks)
Identify two limitations of the price-earnings (P/E) multiple valuation approach and suggest one alternative valuation method that reduces or eliminates these weaknesses. (3 Marks)
Question IV. (11 Marks)
A) Great Stock Corp. will pay a dividend of $5 per share at the end of next year and this dividend is expected to grow at a 0 percent annual rate for five years from that point in time, then at a 3.5 percent rate for the next two years, after which it is expected to grow at a 1 percent rate forever. What value would you place on this stock if a 9.5% rate of return were required? (8 Marks)
B) SuperDuper Stock is expected to pay a dividend next year of $3.07 per share. Its EPS is expected to be $9.86. SuperDuper Stock typical earns 26% on its retained earnings. If an investor is currently willing to pay $72.34 for one share of SuperDuper Stock, what is the required return for this investment? (3 Marks)
Question V. (6 Marks)
A company has just paid an annual dividend of $2.50. You estimate that the dividend will grow negatively by 10% per year (i.e. -10% per year) for the next three years before beginning to grow at an annual rate of 3% indefinitely. The company has a weighted average cost of capital of 6%, an after-tax cost of debt of 3% and a cost of equity of 7%. What are their shares worth today according to the dividend discount model (DDM)? (6 Marks)
Question VI. (10 Marks)
You are given the task of calculating the cost of capital of Kingston Toys. The company faces a tax rate of 40%. The company has 100,000 common shares and 10,000 preferred shares outstanding. Each preferred share has a par value of $60, and is currently priced at 90% of the par value. The preferred shares are paying dividends that total 5% of the par value. You estimate that the beta of the common stock is 1.5. The equity market risk premium is estimated to be 5%, and the risk-free rate is 5%. The company has just paid a dividend of $2 per share. You expect that the dividends will grow at a rate of 15% until Year 4. After Year 4, the dividends are expected to grow at a constant rate of 5% forever. You decide to employ the CAPM approach to calculate the cost of equity.
The company has two different debt issues that are outstanding. The first issue consists of 1,000 semi-annual coupon bonds. Each bond has a face value of $1,000. The annual coupon rate is 10%, and the bonds are currently trading at a YTM that equals 12%. The bonds will mature 10 years from now. The second issue consists of 1,000 zero coupon bonds. Each bond has a face value of $1,000, and will mature 15 years from now. The zero coupon bonds are trading at 50% of their face value.
Using the information provided above, calculate the weighted average cost of capital of Kingston Toys. (10 Marks)
Question VII. (10 Marks)
Using the following table, please answer the question below.
In addition, you know the company you are trying to value has Net Debt of $432 million and 95 million shares outstanding. What is “Slow and Steady” worth on a per share basis, given the publicly traded comparable company analysis shown above? (10 Marks)