Finance & Investment Exam Questions
R1
Consider the two mutually exclusive projects for Company K. Assume the discount rate for
both projects is 8 percent. Project A has an initial cost of 1.8 million and the net cash flows
in the 3 following years are 1.08 million; 0.84 million; 0.87 million, respectively. Project B
will provide a net cash inflow of $0.18 million for the firm during the first year, and the cash
flows are projected to grow at a rate of 2.5 percent per year forever. The project requires an
initial investment of $2.8 million.
a. Give your recommendation on the project that the company should choose.
b. The company is somewhat uncertain about the 2.5 percent cash flow growth rate
assumption for Project B. At what constant growth rate will Project A be similar to Project B
in terms of investment decision?
R2
Suppose: the expected return on the market Rm = 0.15, the riskfree rate Rf = 0.06 and the
market standard deviation sigmaM = 0.15. Assuming that CAPM is correct, answer following
questions:
a. What is the expected return for that security with a standard deviation of returns 0.5 and
beta = 2?
b. What is the expected return on the portfolio with a standard deviation equal to σM? What
is the beta of this portfolio?
c. What is the expected return on an efficient portfolio if its standard deviation is double
that of the market? What is the beta (B) of this portfolio?
R3
As a rational investor, you may want some assurance that your investment will grow and
net you a profit. An expected return and a standard deviation are two statistical measures
that you can use to analyze their portfolios. The expected return is the anticipated amount
of returns that an asset may generate, whereas the standard deviation of an asset measures
the amount that the returns deviate from its mean. The below information shows the
probabilities of occurrence and returns for each asset in different status of economy,
respectively. Note that all calculations are rounded to one-decimal digit.
State of Economy | Probability | Return A | Return B | Return C
Depression | 0.25 | 0.08 | 0.00 | 0.08
Recession | 0.10 | 0.15 | 0.06 | 0.11
Normal | 0.35 | 0.20 | 0.12 | 0.15
Boom | 0.30 | 0.30 | 0.22 | 0.37
a. Calculate the expected return and risk (SD) of each asset.
b. Based on the results in (a), how would you rank the three assets for a rational investor?
c. Construct a portfolio with the weights 4:6 for assets A and C, respectively. Find the
expected return and risk of the portfolio.
d. Comment on the return and risk of this portfolio.
e. Assume the return of asset C in the boom market is -10%. Compare the benefit of
diversification in this situation and the result in part (c).
R4
K Company Inc.'s balance sheet shows the following (in millions of dollars):
Long term liabilities
- Bank Loan: 100
- Bond: 200
Total: 300
Shareholder's equity
- Common stock: 300
- Preferred shares: 150
- Retained earnings: 100
Total: 550
Debt: The bank loan has an interest rate set at the base rate plus an additional 2% premium.
Currently, the base rate is 5%. The company's bonds carry a 12% coupon rate, paid semi-
annually, and will mature in 15 years, with face value equals book value. Similar bonds in
the market have an annual yield to maturity of 10%.
Stock: There are 1,500,000 preferred shares outstanding, each with a par value of $100.
These shares offer a cumulative dividend of 15% and are trading at $108 per share.
Additionally, there are 10,000,000 common shares, currently priced at $45 per share. The
most recent dividend paid on common shares was $6.75, and the company expects
dividends and share prices to grow at a steady rate of 4% annually.
K Company Inc. is a well-established public corporation, subject to a corporate tax rate of
35%.
Required: Calculate K Company Inc.'s weighted average cost of capital.
R5
TechGrow Ltd is evaluating its capital structure to optimize financing costs for a potential
merger with another company. To prepare for this decision, the company has decided to
calculate its weighted average cost of capital (WACC).
The company has 400 million ordinary shares currently trading on the stock market on an
ex-dividend basis at $5.85 per share. TechGrow Ltd's equity beta is 1.15.
In addition, TechGrow Ltd has issued 200 million loan notes with a face value of $1 each,
currently trading on the financial market on an ex-interest basis at $1.035 per loan note.
The loan notes carry an annual interest rate of 6% before tax and are set to be redeemed in
six years at a 6% premium above their face value.
The T-bill rate is 4% per year, while the expected market return is 10% per year. TechGrow
Ltd is subject to a corporate tax rate of 25% annually.
Required: Calculate the weighted average cost of capital (WACC) for TechGrow Ltd.
R6
Companies X and Y in the retail industry have the following financial data:
Company X
Inventory: Beginning 294, Ending 404
Trade receivables: Beginning 411, Ending 597
Trade payables: Beginning 419, Ending 548
Net sales: 4,731
Cost of goods sold: 2,000
Company Y
Inventory: Beginning 2,977, Ending 3,500
Trade receivables: Beginning 3,828, Ending 2,043
Trade payables: Beginning 3,849, Ending 4,500
Net sales: 33,734
Cost of goods sold: 15,298
Questions:
a. Compute the inventory turnover period, trade receivables period, and operating cycle in
days for companies X and Y. Comment on the results.
b. Determine the trade payables period and cash cycle for companies X and Y, and comment
on the findings.
c. What are the implications of a long operating cycle?
d. Using the DuPont identity, explain how a shorter operating cycle can enhance the return
on equity (ROE).
e. How can short-term financing be used to overcome financial difficulties?
R7
Eastbrook Logistics Inc. is evaluating two options for acquiring a new delivery vehicle. The
first option involves entering a 4-year lease agreement with annual payments of $10,000,
made at the start of each year. This lease arrangement includes all maintenance costs. The
second option is to buy the truck outright for $40,000, financed through a bank loan
amortized over 4 years at an annual interest rate of 10%. If Eastbrook purchases the truck,
it will be responsible for maintenance expenses of $1,000 per year, paid at the end of each
year. The vehicle qualifies for 4-year depreciation for the tax purpose straight-line and is
expected to have a residual value of $10,000 after 4 years, at which point Eastbrook intends
to replace it regardless of the chosen acquisition method. The company's combined federal
and state tax rate is 40%. Based on this information, which option leasing or purchasing-
would be more cost-effective for Eastbrook?
R8
Tesla Inc. is evaluating the economic feasibility of developing a new autonomous vehicle
platform.
In Year 1, Tesla must invest $500 million in initial research and prototype development.
In Year 2, an additional $200 million is required for software integration and regulatory
testing.
There is a 50% probability that the platform will be successfully developed and approved
for commercial use.
If successful, Tesla will invest another $100 million in Year 3 to scale up production. In
return, the platform will generate $500 million in revenue in Year 3.
From Years 4 to 6, it is expected to generate $400 million annually from licensing fees and
vehicle sales.
At the end of Year 6, Tesla plans to sell the entire platform to another tech firm for $600
million.
If the platform fails, none of the investments can be recovered. Assume that the market
return premium is 10 percent, the risk-free rate is 2 percent, and the beta risk of the project
is 2.3. All cash flows occur at the end of each year. Calculate the net present value of the
project.
R9
EcoGreen Ltd. and UrbanBuilt Ltd. are identical in every way except their capital structures.
EcoGreen Ltd., a 100% equity-financed corporation, has 5,000 outstanding shares of stock,
which are now worth $20 each. UrbanBuilt Ltd. uses leverage in its capital structure.
UrbanBuilt's debt has a market value of $25,000 and an annual interest rate of 12%. Both
enterprises are expected to generate $350,000 in profits before interest in perpetuity. The
two corporations have a 0% tax rate. Assume that all investors may borrow at 12%.
a. What are the values of EcoGreen Ltd. and UrbanBuilt Ltd.? What is the current market
value of UrbanBuilt Ltd. equity?
b. Create an investment strategy in which an investor buys 20% of EcoGreen Ltd.'s shares
and matches the cost and return of acquiring 20% of UrbanBuilt Ltd.'s equity
R10
Match each of the following concepts on the left with a capital structure theory/hypothesis
on the right:
Concepts
1. Optimal capital structure
2. Agency costs
3. Asymmetric information
Capital Structure Theory/Hypothesis
A. Free cash flow hypothesis
B. Pecking order theory
C. Static trade-off theory of capital structure
