CORPORATE FINANCE I

PRACTICE QUESTIONS FOR FINAL EXAM

Important Notice:

Do NOT start your revision by solving the practice exam. Start your revision with tutorial
questions, lecture notes, and the textbook.

Any questions presented in this paper are for the purpose of revision only. These questions
provide you with an idea about the sort of questions that could be asked. While we made every
effort to design the practice exam similarly to the actual one, it does not perfectly reflect the
structure of the real exam. For example, each question here may have more sub-parts (or fewer
sub-parts) than a question of the real final exam. Refer to the FAQ document for information
on the structure of the real exam. Monash policy requires that the content (i.e., the questions)
of the real exam must be different from this set of questions.

In the real exam, you are NOT required to write the formulas. Rather, you can write your own
application of a formula (i.e., plugging the numbers into the formula) and the marker will know
exactly which formula you are using.

For example, you do not have to write the following formula in your answer:

Re = Ru + D/E(Ru - Rd)

But you can present the calculation in the following way:

Re = 10%+2/3*(10%-8%) =11.33%
SECTION 1: MULTIPLE-CHOICE QUESTIONS
PART 1: 10 QUESTIONS

Question 1
The following table provides the monthly rates of return for Madison Corporation and the
General Electric Company during a six-month period. What is the covariance of two stock
returns?

A. 0.0044

B. 0.6818

C. 0.0717

D. 0.0908

ANSWER: A

Similar to tutorial question 3- Risk and Return I topic, using the calculator steps to find
SD(i)=0.06594, SD(j)=0.082865, and Correlation coef = 0.6818. Thus Cov(i,j) = SD(i)* SD(j)
* Correlation coef = 0.0044.

Question 2:
Andjelkovic-Stewart Limited Company borrows $1 million short-term, $10,000 long-term and
invests these proceeds in inventory. Which of the following statement is TRUE?

A. Increase in working capital

B. No change in working capital

C. Decrease in working capital

D. No change in working capital and no change in cash.

ANSWER: A

Recall WC = Current Assets – Current Liabilities.

Current Assets increase by $1.01 million while Current Liabilities increase by $1 million only.

As a result, WC increases by $10,000.

Question 3:
Déjà vu’ Incorporated currently processes seafood with a unit it purchased several years ago.
The unit, which originally cost $500,000, has a current book value of $250,000. Déjà vu’ Inc.
is considering replacing the existing unit with a newer, more efficient one. The new unit will
cost $750,000 and will also require an initial increase in net working capital of $40,000 (t=0).
The new unit will be depreciated on a straight-line basis over five years to a zero balance. The
existing unit is being depreciated at a rate of $50,000 per year. Déjà vu’ Inc. expects to sell the
existing machine today for $275,000. Déjà vu’ Inc. tax rate is 30%.
If Déjà vu’ Inc. purchases the new unit, annual revenues are expected to increase on an annual
basis by $100,000 (due to increased capacity), and annual operating costs (exclusive of
depreciation) are expected to decrease by $20,000 per year. Annual revenues and operating
costs are expected to remain constant at this new level over the five-year life of the project (so
no adjustment should be made to these incremental cash flows). Accumulated net working
capital will be fully recovered at the end of five years. What is the project’s terminal cash flow?
A. $114,000
B. $169,000
C. $154,000
D. $522,500
ANSWER: C
CF5 = (Incremental Rev – Incremental OpEx – Incremental DA)*(1-tax rate) + Incremental
DA + NWC Recovery = (100,000 + 20,000 – 100,000)*(1-0.3) + 100,000 + 40,000 =
$154,000.

Question 4:
Beta Airlines is currently an unlevered firm and has a cost of equity capital of 20 percent. The
company expects to generate $153.85 in earnings before interest and taxes (EBIT) in
perpetuity. The corporate tax rate is 35 percent, implying after tax earnings of $100. All
earnings after tax are paid out as dividends. The firm is considering a capital restructuring to
allow $200 of debt. Its cost of debt capital is 10 percent. What will the new value of Beta
Airlines be (after restructuring)?
A. $570
B. $500
C. $153.85
D. $769.25
ANSWER: A
Vu=EBIT × (1-t) / Ru=100/0.2=$500.
VL= Vu+ t × Debt=500+0.35×200=$570.

Question 5:
The table below provides information on three risky assets: A, B and C in different states of
the economy. The expected return on the market is 9% and the risk-free rate is 3%. Which asset
has the lowest expected return?

A. A

B. B

C. C

D. A and B

ANSWER: B
E(RA) = 0.098, E(RB) = 0.076, E(RC) = 0.12

Question 6
Locomotive Corporation, an all-equity firm, currently has market capitalization of $10 million
and 500,000 shares of common stock outstanding. It has an equity cost of capital of 10 percent.
The company is planning to repurchase part of its common stocks by issuing $4 million
corporate debt. The cost of this corporate debt is 8 percent per year. Assume perfect capital
markets. What is the expected return on the equity of an otherwise identical levered firm?
A. 11.33%
B. 10%
C. 13.11%
D. 11.31%
ANSWER: A
After the debt issue:
Debt/Equity ratio=4/6=2/3
re = ru + D/E(ru - rd)=10%+2/3*(10%-8%)=11.33%

Question 7
Which of the following is a reason why incremental earnings may be different from incremental
cash flows?

A. Changes in accounts receivable reflects non-cash sales present in incremental earnings that
are not incremental cash flows.

B. Depreciation is a cash expense, but does not appear in incremental earnings.

C. Capital expenditures appear on the income statement. However, as these costs are
depreciated over time, they should not be present in incremental cash flows.

D. Firms pay taxes based on incremental cash flows, not incremental earnings.

ANSWER: A

Question 8
What is the undiscounted cash flow in the final year of an investment, assuming $10,000 after-
tax cash flows from operations, $1,000 from the sale of a fully depreciated machine, $2,000
initial requirement for additional working capital, and a 35% tax rate?
A. $8,450

B. $12,600

C. 12,650

D. $14,000

ANSWER: C
CFn = 10,000 + 1,000*(1-0.35) + 2,000 = $12,650

Question 9
In order to use the WACC to evaluate a future project's flows, which of the following must
hold?
A. The project will be financed with the same proportion of debt and equity as the company.
B. The systematic risk of the project is the same as the overall systematic risk of the company.
C. The project must be viable.
D. A and B above.
ANSWER: D

Question 10
According to M&M Proposition 2, the cost of a company's equity
A. increases with the debt-to-equity ratio.
B. decreases with the debt-to-equity ratio.
C. increases and then falls with the debt-to-equity ratio.
D. decreases and then increases with the debt-to-equity ratio.
ANSWER: A

PART 2: 5 QUESTIONS

Question 11:
You are given the following variance – covariance matrix on two shares and the market
portfolio. Risk free rate is 6% per annum. Expected market return is 14% per annum. You have
$500,000 available to invest. Assume that you are forming a portfolio by investing $200,000
in Share A, $200,000 in Share B and the balance of the $500,000 in risk free asset. What is the
standard deviation of this portfolio?

A. 0.0014

B. 0.6000

C. 0.0324

D. 0.1800

ANSWER: D
Note: after investing $200,000 in Share A, $200,000 in Share B, the balance of the $500,000
is $100,000 (=500,000-200,000-200,000) invested in risk free asset. Thus wA = 0.4, wB = 0.4,
wRf = 0.2.

Var(A) = 0.04, Var(B) = 0.09, Cov(A,B) = 0.036.

Thus, Var(P) = 0.4^2 * 0.04 + 0.4^2 * 0.09 + 2 * 0.4 * 0.4 * 0.036, or SD(P) = 0.18

Question 12
The Fast Reader Company supplies bulletin board services to numerous hotel chains
nationwide. The owner of the firm is investigating the desirability of employing a billing firm
to do her billing and collections. Because the billing firm specialises in these services,
collection float will be reduced by
25 days. Average daily collections are $12,000 and the owner can earn 9% annually (expressed
as an APR with monthly compounding) on her investments. If the billing firm charges $475
per month, What is the value today of the billing firm's charges?
A. $63,333

B. $5,277

C. $12,000

D. $66,333

ANSWER: A

Amount available immediately = Average daily collections * Number of days collection float
is reduced = $12,000*25 = $300,000.
Assuming the billing firm can reduce the collection float immediately, as soon as Fast Reader
starts the service they will receive $300,000.
PV of billing firm's charges = billing firm's monthly charges/monthly discount rate, where
monthly discount rate = APR/12 = 9%/12 = 0.75%.
Thus, the present value of the billing firm's charges is $475/0.0075 = $63,333.

Question 13
Al Corporation plans to finance a new investment with leverage. It plans to borrow $56 million
to finance the new investment. The firm will pay interest only on this loan each year, and it
will maintain an outstanding balance of $56 million on the loan. After making the investment,
the firm expects to earn annual free cash flows of $12 million. However, due to reduced sales
and other financial distress costs, the firm's expected annual free cash flows will decline to $11
million. The firm currently has 5.7 million shares outstanding, and it has no other assets or
opportunities. Assume that the unlevered discount rate for the firm's future free cash flows is
8.9% and the firm's corporate tax rate is 30%. What is the firm's share price today?
A. $14.18

B. $12.41

C. $11.48

D. $14.81

ANSWER: D

Following MM2 Theory: VL = Vu + t*D

where t =0.3, D =$56M, Vu = EBIT*(1-t)/ru = $11M/0.089 (the firm's expected annual free
cash flows will decline to $11 million)
Also, VL = D+E = D + P*N, where P is the share price, and N = 5.7M shares.
Thus,
P = ($11M/0.089 – $56M + 0.3*$56M)/5.7M = $14.81 per share.

Question 14
Wernham-Mifflin is considering launching a new line of pentagonal-shaped paper. You have
the following information:

 Revenues due to the sale of the new product are expected to be $90 million annually.

 Total paper production costs will increase from the current level of $22 million annually to
$63 million annually after the product launch.

 Top sales agent Michael Scarn will be reassigned from other projects to sell the new product
line. Sales of those other products are expected to decline by $12 million annually.

 The project will make use of an existing paper mill, built last year at a cost of $38 million.
The mill is being depreciated using prime cost over a useful life of 16 years.

 Wernham-Mifflin currently pays taxes at a marginal rate of 26%.

 Total annual incremental cash flows for the project are expected to remain constant for the
next 16 years. After this period, the project’s total incremental cash flows will decline at a rate
of 5% annually and will be received in perpetuity.

What is the present value of the project if the annual project discount rate is 6.0%?

A. $369.78 million

B. $276.70 million

C. $93.08 million

D. $270.38 million

ANSWER: A

Incremental costs for the project are $63 - 22 = $41 million. After tax side effects are $12 −
(12 × 0.26) = $8.88 million. The plant is a sunk cost and is not incremental to the project.
Similarly, the plant’s depreciation is also not incremental and should be ignored. Therefore,
incremental earnings for the project is determined as follows:

No adjustments are necessary due to capital expenditures, depreciation, after-tax salvage, or

change in net working capital. Therefore, incremental cash flows are $27.38 million. The
investment is a 16-year annuity, and a growing perpetuity with its first payment in 17 years.

The annuity value can be found using calculator steps: n =16 periods, r=6%, PMT=27.38, we
get PV0 = $276.70.

PV16 of the growing perpetuity = 𝐶𝐹17/(𝑟−𝑔) gives the value one period before the first
payment, or the value at t = 16. This must be discounted 16 years to get the present value. The
growth rate is g = -0.05 as the cash flows are declining at 5% annually. The initial cash flow
at t = 17 is equal to the t = 16 cash flow after a 5% decline, 27.38*(1-0.05) = 26.011. PV0 of
the growing perpetuity = 1/(1+𝑟)^16 × 𝐶𝐹17/(𝑟−𝑔) = 1/1.06^16 × 26.011/[0.06−(−0.05)] =
$93.08.
Therefore, the present value of the investment is: 276.70 + 93.08 = $369.78 million.

Question 15
A firm expects a project to have the following incremental Income Statement (all values in
millions of dollars):
Fiscal year 2015 2016 2017
Revenues $56.70 $69.60 $61.80

Costs -34.8 -42.7 -37.9

Depreciation -1.9 -1.9 -1.9
EBIT 20 25 22

The project’s incremental pro-forma balance sheet is expected to contain the following working
capital items at the end of those fiscal years (all values in millions of dollars):
Assets Liabilities

Fiscal year 2015

Inventories $2.80 Accounts payable $2.00
Accounts receivable 1.3

Fiscal year 2016

Inventories 3.5 Accounts payable 2.5
Accounts receivable 1.6

Fiscal year 2017

Inventories 3.1 Accounts payable 2.2
Accounts receivable 1.4

In 2016, expected incremental capital expenditures total $2.9 million and incremental after tax
salvage is expected to be $5.0 million. The tax rate for the project is 30%. What are the expected
incremental cash flows from the project in 2016?
A. $21.5 million
B. $21 million
C. $17.5 million
D. $17 million
ANSWER: B

Incremental cash flows = Incremental earnings - capital expenditures + depreciation + after-

tax salvage - change in net working capital
Incremental earnings = EBIT − taxes = 25.0 − 25.0 × 0.3 = 17.5.
Capital expenditures, depreciation, and after- tax salvage are given. So, all that remains is
to compute the change in net working capital.

NWC = Accounts receivable + Inventories − Accounts payable.

2016 NWC is 2.6 and 2015 NWC is 2.1. So the change in net working capital is 2.6-2.1 =0.5.
Therefore, incremental cash flows = 17.5 -2.9 + 1.9 + 5.0 - 0.5 = $21 million.

SECTION 2: SHORT ANSWER QUESTIONS

Question 16
You are considering two identical firms one levered the other not. Both firms have expected
EBIT of $600. The value of the unlevered firm (vU) is $2000. The corporate tax rate (t) is 30%.
The cost of debt (rD) is 10%, and the ratio of debt to equity (D/E) is 1 for the levered firm.
(a) Calculate the cost of equity for both the levered (rL) and unlevered firms (rU).
(b) Calculate the weighted average cost of capital for each firm.
(c) Why is the cost of equity higher for the levered firm, but the WACC lower?
(d) In an MM world without taxes, what is the optimal capital structure?

Suggested solution:

(a) Calculate the cost of equity for both the levered (rL) and unlevered firms (rU).
rU = EBIT(1-t)/vU = 600(1-0.30)/2000 = 21%
rL = rU + (rU – rD)(1-t)(D/E) = 0.21 + (0.21-0.10)(0.70)(0.50/0.50) = 28.70%

(b) Calculate the weighted average cost of capital for each firm.
The unlevered firm’s WACC = 21%
The levered firm’s WACC = 0.10*(0.7)*(0.5) + 0.287*(0.5) = 17.85%

(c) Why is the cost of equity higher for the levered firm, but the WACC lower?
Equity holders bear more of the financial risk in the levered firm.
WACC falls because debt is cheaper than equity and plus interest payments are tax deductable.
Gains from use of debt are not completely offset by increase in cost of equity due to tax shield.

(d) In an MM world without taxes, what is the optimal capital structure?

Capital structure is irrelevant in an MM world without taxes

Question 17
Floorstreet Stock Raiders Incorporated (FSR) has the following capital structure: Debt 25%,
Preferred Stock 15%, Common Equity 60%. FSR’s beta is 1.5. FSR’s expected net income this
year is $34,285.72, its established dividend payout ratio is 30 percent, its corporate tax rate is
40 percent, and investors expect earnings and dividends to grow at a constant rate of 9 percent
in the future. FSR paid a dividend of $3.60 per share on its 76,000 issued ordinary shares. The
Treasury note rate is 4.3% and the market risk premium is 8%. FSR can obtain new capital in
the following ways:

+ Preferred: Issue 10,800 new preference shares committing FSR’s to a dividend of $11. The
preference shares can be sold to the public at a price of $95 per share.
+ Debt: Issue 1,800 ten year $1,000 par value bonds to the public. The bonds will pay 11.115%
coupons (annually) and have a current yield to maturity of 12%.
a. What is the firm’s cost of debt?
b. What is the firm’s cost of preferred equity?
c. What is the firm’s cost of ordinary equity?
d. What is the firm’s overall cost of capital?
e. The following investment opportunities have the same level of risk with FSR. Which projects
should FSR accept? Why?

Suggested solution:

a. What is the firm’s cost of debt?

Current YTM = Pretax cost of debt (rD) = 12%
The firm’s after-tax cost of debt = rD*(1-t) = 12% * (1-0.4) = 7.2%

b. What is the firm’s cost of preferred equity?

The firm’s cost of preferred equity = $11/$95 = 11.6%

c. What is the firm’s cost of ordinary equity?

SML model: the firm’s cost of ordinary equity = Risk-free rate + Beta * Market risk premium
= 4.3% + 1.5*8% = 16.3%

d. What is the firm’s overall cost of capital?

Given the firm’s capital structure: Debt 25%, Preferred Equity 15%, Ordinary Equity 60%
The firm’s WACC = 25%*7.2% + 15%*11.6% + 60%*16.3% = 13.32%.

e. Given the following investment opportunities. Which projects should FSR accept? Why?
Given the same level of risk, FSR should accept A, B, C and D as all of them are affordable
(no constraint provided) and provide a return greater than the cost of funds.

Question 18
Mick Ronalds is a fast-food establishment that is considering replacing its fryolators. The cost
of the new plant is $200,000. For tax purposes, depreciation is allowed at 20% on prime cost
(this means, straight line over the next five years). The plant would be sold for $40,000 at the
end of its ten-year life.
Operating expenses will be $90,000 per annum, compared with $120,000 a year for the existing
fryolators. However, if the existing plant were kept, $70,000 would need to be spent in four
years time on a major overhaul, which would be immediately expensed for tax purposes.
The existing plant is being depreciated at $6,000 a year. It now has a book value of $60,000.
This plant could be sold today for $50,000. Alternatively, it could be used for the next ten years
and then scrapped for nil value.
The tax rate is 30%. Mick Ronald’s equity beta is 1.00, the pre-tax cost of debt is 20% and the
risk free rate and market return are 6% and 14%, respectively. Mick Ronald’s debt to equity
ratio is 1.

a. What is the firm’s overall cost of capital?

b. What is the firm’s initial investment?
c. What is the firm’s operating cash flow in year 1?
d. What is the firm’s operating cash flow in year 4?
e. What is the firm’s operating cash flow in year 6?
f. What is the firm’s terminal cash flow?

Suggested solution:

a. What is the firm’s overall cost of capital?

SML model: Cost of equity = 0.06 + 1.00×(0.14-0.06) = 0.14
After tax cost of debt = 0.2*(1-0.3) = 0.14
D/E = 1 so D/(D+E) = 0.5, E/(D+E) = 0.5
WACC = 0.5*0.14 + 0.5*0.14 = 0.14

b. What is the firm’s initial investment?

Given the capital loss from the sale of old plant: 50,000-60,000 = -$10,000, the Tax Refund on
the sale of old plant = 30%*10,000 = +3,000 (note: tax payment if a capital gain is realised
from the sale, e.g the tutorial question, and tax refund if there is a capital loss).

CF00 = - Cost of New Plant + Sale of existing Plant + Tax Refund on Sale of Old Plant
= -200,000 + 50,000 + 3,000 = -$147,000

c. What is the firm’s operating cash flow in year 1?

In the context of this question: Operating CFs = (Incremental Rev – Incremental OpEx –
Incremental DA)*(1-tax rate) + Incremental DA, where
Incremental Rev = 0,
Operating expenses (OpEx) decrease from $120,000 to $90,000, implying cost savings of
$30,000,
Incremental DA = DA of New plant – DA of Old plant
DA of New plant in years 1-5 = 200,000/5 = $40,000
DA of Old plant is given as $6,000
Thus, Incremental DA is $34,000 in years 1-5, and is -$6,000 in years 6-10.
Overhaul cost of $70,000 is spent on Old Plant in year 4 only.

CF1=CF2=CF3=CF5= (0+30,000-34,000)*(1-0.3)+34,000 = $31,200.

d. What is the firm’s operating cash flow in year 4?
Overhaul cost of $70,000 spent on Old Plant in year 4 is a cost saving as this amount will not
be spent if Old Plan is replaced. Thus, total cost savings in year 4 = 30,000 + 70,000 =
$100,000

CF4= (0+100,000-34,000)*(1-0.3)+34,000 = $80,200.

e. What is the firm’s operating cash flow in year 6?

Given the new plant is fully depreciated at the end of year 5, Incremental DA is -$6,000 (=0-
6000) in years 6-10. Thus,

CF6-9 = (0+30,000+6,000)*(1-0.3)-6,000 = $19,200.

f. What is the firm’s terminal cash flow?

CF10 = Operating CF + Sale of New Plant – Capital Gain Tax from the Sale of New Plant

= 19,200 + 40,000 – (40,000-0)*0.3 = $47,200.

Question 19
What is the relationship between the covariance and the correlation coefficient?

Suggested answer:

The covariance between the returns of assets i and j is affected by the variability of these two
asset returns. Therefore, it is difficult to interpret the covariance figures without taking into
account the variability of each return series. In contrast, the correlation coefficient is obtained
by standardising the covariance for the individual variability of the two return series, that is:

Correlation coefficient(i,j) = Covariance(i,j)/[SD(i)*SD(j)]

Thus, the correlation coefficient can only vary in the range of -1 to +1. A value of +1 would
indicate a perfect linear positive relationship between the two asset returns.