Commerce 2FA3 Final Exam August 7, 2002

Student Number: _______________________

Commerce 2FA3: Introduction to Finance

Time allowed for this test: 3 hours. August 7, 2002: 7 - 10 p. m. Instructions:

a) This exam has 13 pages, including this one. Please check that you are not missing any pages and bring any problems to the attention of the invigilator.

b) Each multiple-choice question has only one right answer. Circle the letter of the best answer on the exam page. Right answers will be worth 2 marks and wrong or missing answers will be worth zero. There is no correction factor.

c) Long answer questions are to be answered on the question paper. All work must be shown to receive full marks. If you are running short of space and decide to continue the answer on another page, indicate where the rest of the answer is located. The marker cannot give you marks for an answer that they cannot find.

d) A formula sheet will be distributed with this exam, no other references are allowed.

e)

Use of the McMaster calculator (Casio FX-991) or similar

scientific calculator is allowed for

Multiple choice /50

Problem 1 /10

Problem 2 /10

Problem 3 /10

Problem 4 /10

Multiple choice questions: 2 marks each.

1) What is the present value of the tax shield on a $75,000 class 8 asset (20%) for a firm with a cost of capital of 10.5%, an average tax rate of 27% and a marginal tax rate of 34% that has net acquisitions of $100,000 in class 8?

a) $12,648 b) $13,279 c) $15,927 d) $16,721

e) none of the above

2) A project with an apparently negative NPV may become viable if you consider…

a) AAR instead of IRR b) managerial options c) payback instead of NPV

d) the effective annual annuity (EAA) e) none of the above

3) HPL Inc. is evaluating two mutually exclusive capital budgeting proposals. Project A has a NPV of $50,000 and would last 4 years after which time it can be repeated. Project B has a NPV of $75,000 and can be repeated after 7 years. HPL's cost of capital is 9.5%. Which Project is preferred?

a) Project B because the NPV is higher

b) Project B because it doesn't have to be repeated as often c) Project A on the basis of EAA

4) If projects A and B are positively interdependent, then _________. a) NPV A+B > NPV A + NPV B

b) NPV A+B < NPV A + NPV B

c) NPV A+B = NPV A + NPV B

d) You can’t do both A and B e) None of the above.

5) An electrical utility has the control room built with the capability to control up to six generators although the project only calls for four generators to be installed. This gives the utility ___________.

a) a strategic option b) the option to wait c) a contraction option d) an expansion option e) an abandonment option

6) Projected cash flow is typically defined to be a) the largest possible cash flow

b) the best case expected cash flow

c) an average of the possible cash flows

d) the cash flow that results in the lowest NPV but still allows the project to be accepted

e) the most likely cash flow

7) Which of the following statements regarding NPV analysis is correct? a) Negative NPV projects should be scrutinized to make sure there is a

sound economic basis underlying them

b) NPV calculations do not depend on cash flow projections

c) Positive NPV projects that have relatively low levels of fixed costs should be more heavily scrutinized than projects with relatively high levels of fixed costs

d) NPV calculations are only as good as the information that goes into their calculation

8) If markets are efficient in the semi-strong form, which of the following situations should yield excess returns?

a) Obtaining insider information

b) Analyzing a company’s earnings report

c) Identifying a pattern in a company’s stock price d) Following the advice of your broker’s newsletter e) None of the above

9) The concept of an efficient market implies a) stock prices do not fluctuate

b) prices reflect all available information c) there is no upward trend in stock prices

d) all shares of stock have the same expected returns e) none of the above

10) Securities R and T both have an expected return of 15% with a standard deviation of 25%. If the two securities are uncorrelated, what is the standard deviation of a portfolio that has 30% in security R and 70% in security T?

a) 340 basis points b) 15%

c) 18% d) 25%

e) None of the above

11) In a world with 3 risky securities and a risk-free asset, Joe has an efficient portfolio. His holdings consist of $400 in asset A, $350 in Asset B, $500 in asset C and $500 in the risk-free asset. Susan has $500 to invest. If she is not interested in borrowing or lending, how much should she invest in Asset C if she wants an efficient portfolio?

a) $100 b) $143 c) $200 d) $500

12) Given that the standard deviation of returns for Security C is 27.5%, the variance of returns for the market is 133 basis points and the correlation between C and the market is 0.42. What is the beta (β) of security C?

a) 0.80 b) 0.95 c) 1.05 d) 1.25

e) none of the above

13) Under CAPM, what is beta? a) the risk-free rate

b) the market risk premium

c) a measure of the systematic risk in a security d) the standard deviation of the return of a security e) a measure of the company specific risk in a security

14) A firm with a beta of 1.125 is expected to pay a dividend of $2.25 a year from now. If the expected return on the market portfolio is 14% and the risk free rate is 6%, at what rate are dividends expected to grow it the share is currently prices at $22.50?

a) 5% b) 6% c) 7% d) 8%

e) none of the above

15) A firm with a constant dividend of $2.50 per share has a beta of 0.6 and is trading at $25 per share. If the risk-free rate of return is 5%, what is the return on the market portfolio?

a) 10% b) 13% c) 16% d) 19%

16) Short-run financial risk arising from the need to buy or sell at uncertain prices or rates in the near future is called __________________.

a) risk maximization b) economic exposure c) translation exposure d) transactions exposure e) volatility maximization

17) A local retail store allows you to return the merchandise you purchase and get your money back for up to 30 days after the purchase date. The store has, in effect, provided each shopper with _______________ options.

a) strategic b) American call c) European call d) American put e) European put

18) Hedging an asset with contracts written on a similar, but not identical, asset is called:

a) open trading b) cross-hedging c) open-hedging d) primary trading e) perfect-hedging

19) Which of the following is a characteristic difference between a warrant and a call option?

a) A call option will typically have a longer maturity than a warrant. b) Call options are issued by individuals while warrants are issued

by firms.

c) Call options can be allowed to expire while warrants cannot. d) Neither warrants nor call options affect firm value.

20) The value of an option if it were to expire today is called an option's a) time value

b) strike value c) market value d) intrinsic value e) volatility value

21) Which of the following contracts obligates the writer (issuer) to buy an asset for a specified price if the contract is exercised?

a) A put option b) A call option c) A swap contract d) A futures contract e) A forward contract

22) DSW Inc. is issuing 20-year, 7% coupon, $1,000 face value bonds that have 20 warrants attached to each bond. These bonds are selling for par. Similar bonds without warrants are selling at a price that gives a YTM of 8%. What is the value of one warrant?

a) $3.40 b) $4.95 c) $8.11 d) $12.46

e) none of the above

23) When would it make sense to exercise an American option before expiry, when the underlying asset is a non-dividend paying stock?

a) the time value of the option exceeds 75¢ b) anytime that the intrinsic value is positive

c) if the price of the option is greater than its intrinsic value

24) Which of the following describes the net effect of a perfect hedge? a) the hedger can only lose money if prices change

b) the hedger can only make money if prices change

c) the hedger can either make or lose money if prices change

d) the hedger will neither make nor lose money if prices change e) prices will not change

25) Hedging will not increase the value of the firm when a) the level of systematic of the firm risk is reduced

Problem 1

QSR Inc. is evaluating a capital budgeting proposal that calls for an investment of $835,000 (Class 42, 25%) and yields cash flows of $150,000 per year for the next 15 years with a salvage value of $50,000. QSR has a marginal tax rate of 30% and a cost of capital of 11%.

a) Should QSR Inc. accept this proposal. Why? b) Find the EAA for this proposal.

c) When would you want to use the EAA?

C $ 835,000

d 25%

t 30%

r 11%

CF $ 150,000

After tax $ 105,000 150,000*(1-T)

I0 $ (835,000)

PVTS $ 165,339 CdT/(r+d)*1.055/1.11 PV CF $ 755,041 After tax * PVIFA(11%,15) PV Salvage $ 10,450 50,000*(1+r) -15

PVTS lost $ (2,177) 50,000dT/(r+d)*(1+r) -15

NPV $ 93,653

EAA $ 13,024 NPV / PVIFA(11%,15)

The project should be accepted because the NPV > 0.

Problem 2

KTH Inc. is restricted by a bond covenant to invest no more than $5 million per year in capital expenditures. The management has identified the following capital budgeting proposals.

Project Cost, $ thousands NPV, $thousands PI

A 1,750 125 1.071

B 1,150 105 1.091

C 2,250 95 1.042

D 1,350 110 1.081

E 2,000 175 1.088

a) Find the PI for all projects.

b) Which projects should KTH accept?

c) If the rejected projects could all be done next year, how much has the capital rationing cost KTH?

d) If the bond issue is callable, what factors should be considered in deciding whether to call the bond issue?

PI = (NPV + Cost) / Cost. See table above for answers.

Adding projects in order of PI gives B, E, and D. At that point we only have $500,000 left and can't afford another project. However for $400,000 we can "upgrade" from Project D to project A, increasing the overall NPV by $25,000. So we should do B, E, and A.

The cost is the reduction in present value of the skipped projects since all of the cash flows will be received one year later. Without a cost of capital you can't get an exact dollar value. If you assume a discount rate of 10%, that reduction would be 205-205/1.1 = $18,636

Things to consider;

Problem 3

You have the following ex-ante return data about 2 securities.

Event Probability RA RB

A 30% 10% 20%

B 30% 15% 5%

C 40% 20% 22%

a) Find the expected return and standard deviation of each of the securities. b) Find the composition of the minimum risk portfolio that can be made with

these 2 securities as well as the expected return and standard deviation of that portfolio.

c) If we add a risk free security as another possible investment, would we be likely to invest in the portfolio above? Explain.

Event Probability RA E(R) Deviation π D2

A 30% 10% 3.00% -5.500% 0.000908

B 30% 15% 4.50% -0.500% 7.5E-06

C 40% 20% 8.00% 4.500% 0.00081

15.50% Variance 0.001725

SD 4.15%

Event Probability RB E(R) Deviation π D2

A 30% 20% 6.00% 3.700% 0.000411

B 30% 5% 1.50% -11.300% 0.003831

C 40% 22% 8.80% 5.700% 0.0013

16.30% Variance 0.005541

SD 7.44%

Event Probability π _{x D x D}

X*A 0.812992 A 30% -0.00061

X*B 0.187008 B 30% 0.00017

E(RP) 15.65% C 40% 0.001026

Variance p 0.001512 COV 0.000585

Problem 4

In a world where the CAPM is appropriate, you have the following information about the standard deviation, correlation with the market and expected return of two available securities.

Security σ i ρ i, m E(R i) β i

A 25% 0.60 16.0% _1.25

B 18% 0.30 13.2% _0.45

a) Given that the variance of the market is 144 basis points (0.0144) find the beta of each security.

b) Find the risk-free rate of return and the expected return on the market portfolio.

c) A third security has an expected return of 10% and a variance of 0.0576. What is the correlation between this security and the market?

d) What is the expected return and beta of a portfolio with 60% invested in security A and the rest in security B?

To find the beta, use the formula σ i x ρ i, m / σ m.

Use the SML to find the return equations for securities A and B. This gives you 2 equations and 2 unknowns.

Rf = 11.625%, Rm = 15.125%

Use the SML to find the beta for security C. 10% = 11.625% + (15.125 - 11.625)β β = -0.4642857

β = σ i x ρ i, m / σ m

σ i = -0.23214

The portfolio beta = 0.6*1.25 + 0.4*0.45 = 0.93

Problem 5

Your company is considering hedging a purchase of 4,000 barrels of oil, 3 months from now. They want to lock in a currently available price of $23.75 per barrel. The market price for a $23.75 per barrel call option on oil is $1.75 per barrel. Assume that the market price for oil 3 months from now turns out to be $25.00 per barrel.

a) Show the net cash flows and any gains or losses if the company does not hedge, and for hedging using; a forward contract, futures contracts, or option contracts.

b) What types of risks is the company exposed to with each of the above strategies?

Budgeted Expenditure: $23.75 x 4,000 = $95,000

No hedging:

cash flow in 3 months = $25 x 4,000 = $100,000 Net Loss = $5,000.

Type of risk = price risk.

Forward contract:

cash flow in 3 months = $23.75 x 4,000 = $95,000 Gain over no hedging = $5,000

Type of risk = credit risk, other party can default. No price risk.

Futures contracts:

marking to market payments received = $5,000 cash flow in 3 months = $25 x 4,000 = $100,000 Gain over no hedging = $5,000

Type of risk = liquidity risk, marking to market payments come before maturity. Possible basis risk if not a perfect match. No price risk.

Option contracts: