The Hang Seng University of Hong Kong

Bachelor Degree Programmes

2019-2020 Semester 2 Examination

Module Code : FIN2001

Module Title : Financial Management
Date : 14 May 2020
Time Allowed : 3 hours

Notes to Candidates:

1. This question paper has 8 pages (including this cover sheet).

2. There are TWO sections in this paper:

Section A : 15 multiple-choice questions each with 2 marks. Answer ALL
(30 marks) questions.

Section B : 6 questions in total. Answer ALL questions. Marks allocated to

(70 marks) parts of questions are indicated in brackets.

3. The examination will be marked out of 100.

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Section A: Multiple Choice Questions (30%, 15 MCQs, 2 marks each)

1. Donald has been promoted and is now in charge of all fixed asset purchases. In
other words, Donald is in charge of:

A. capital structure management.

B. capital budgeting decision.
C. working capital management.

2. Sofia Ltd. is financed with 40 percent debt and 60 percent equity. This mixture
of debt and equity is referred to as the firm's:

A. capital structure.
B. capital budget.
C. working capital.

3. The potential conflict of interest between a firm's owners and its managers is
referred to as which type of conflict?

A. Agency.
B. Organizational.
C. Structural.

4. Which one of the following forms of business organization offers liability

protection to some of its owners but not to all of its owners?

A. Sole proprietorship.
B. General partnership.
C. Limited partnership.

5. Which one of the following will decrease the net working capital of a firm?

A. Obtaining a three-year loan and using the proceeds to buy inventory.

B. Selling inventory at a profit.
C. Making a payment on a long-term debt.

6. Highly liquid assets:

A. increase the probability a firm will face financial difficulties.

B. generally produce a high rate of return.
C. can be sold quickly at close to full value.

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7. Which one of the following will increase the cash flow from assets for a tax-
paying firm, all else constant?

A. An increase in net capital spending.

B. An increase in depreciation.
C. A decrease in dividends paid.

8. Cash flow to creditors is equal to:

A. beginning long-term debt minus ending long-term debt plus interest paid.
B. ending long-term debt minus beginning long-term debt plus interest paid.
C. cash flow from assets plus cash flow to stockholders.

9. Common-size financial statements present all balance sheet account values as a

percentage of:

A. total assets.
B. total equity.
C. Total sales.

10. Which one of the following statements is true concerning the price-earnings (PE)
ratio?

A. A high PE ratio may indicate that a firm is expected to grow significantly.

B. A PE ratio of 16 indicates that investors are willing to pay $1 for every
$16 of current earnings.
C. The PE ratio is a constant value for each firm.

11. The DuPont identity can be used to help a financial manager to determine the:
I. degree of financial leverage used by a firm.
II. operating efficiency of a firm.
III. utilization rate of a firm's assets.
IV. rate of return on a firm's assets.

A. II, III, and IV only

B. I, II, and III only
C. I, II, III, and IV

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12. Terry invested $2,000 today in an investment that pays 6.5 percent annual
interest. Which one of the following statements is correct, assuming all interest
is reinvested?

A. Terry will earn the same amount of interest each year.

B. Terry could have the same future value and invest less than $2,000
initially if he could earn more than 6.5 percent annual interest.
C. Terry will be earning simple interest.

13. Today, Stacy is investing $26,000 at 6.0 percent, compounded annually, for 4
years. How much additional income could he earn if he had invested this amount
at 7 percent, compounded annually?

A. $1,044.77
B. $1,256.30
C. $1,487.52

14. You have $5,000 to invest for the next 45 years. You are offered an investment
plan that will pay you 6 percent per year for the first 15 years and 10 percent per
year for the last 30 years. How much will you have at the end of the 45 years?
How much will you have if the investment plan pays you 10 percent per year
for the first 15 years and 6 percent per year for the next 30 years?

A. $209,092.54; $119,959.94
B. $209,092.54; $201,516.38
C. $209,092.54; $209,092.52

15. Company ABC is considering making and selling custom kites in two sizes. The
small kites would be priced at $10 and the large kites would be $24. The variable
cost per unit of small kites and large kites is $5 and $11, respectively. Jill, the
owner, feels that she can sell 2,600 of the small kites and 1,700 of the large kites
each year. The fixed costs would be only $2,100 a year and the tax rate is 34
percent. What is the annual operating cash flow if the annual depreciation
expense is $1,000?

A. $21,120.
B. $21,780.
C. $22,120.

END OF SECTION A

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Section B: Structural Questions (70%, marks to each question are as indicated)

Question 1 (8 marks)

a) You will receive $1,000 from your parents as a birthday gift in half year. You have
decided to invest it at 5% per annual until you have $1,629. How many years will
you have to wait from NOW until you achieve your target?
(3 marks)

b) You will receive fifty annual payments of $1,000 each beginning at the end of the
40th year. What is the present value of these payments? The appropriate annual
discount rate is 10%.
(5 marks)

Question 2 (8 marks)

a) A bond of 10 years maturity is left with 8 years to maturity today. Its coupon rate is
10%, paying annual coupon with par value of $1,000. What is the price of the bond
today if the yield to maturity is 8%? Is it a premium bond or discount bond?
(5 marks)

b) Recently, a 30-year corporate bond issued by Liz Co. has been downgraded by a
credit rating agency from AAA to B. Other things being constant, what would you
expect to happen to the price and yield of the bond as a consequence of the
downgrade?
(3 marks)

Question 3 (10 marks)

LogiTel Corp. is a public company which had issued both common stock and
cumulative preferred stock. In its recent meeting, management has decided not to pay
dividends in the next 3 years.

a) John, a shareholder of LogiTel, is unhappy with the management’s decision and

intends to sue the company for not paying dividends. Briefly comment on John’s
intention.
(2 marks)

b) Briefly explain the cumulative feature of preferred stock.

(2 marks)

c) Assume that LogiTel will pay a dividend of $1 per share of common stock at the
end of year 4. Dividends are expected to grow at 5% per year in year 5 and 6. After
that, dividends will growth at a constant rate of 1% per year indefinitely. Calculate
the current common stock price if the required return is 8%.
(6 marks)

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Question 4 (14 marks)

Consider the following two mutually exclusive projects:

Year Cash Flow (Project I) Cash Flow (Project II)

0 -$12,300 -$44,000
1 $1,800 $14,000
2 $6,000 $30,000
3 $2,000 $5,000
4 $5,000 $10,000
5 $7,000 $5,000

The required return is 10% for both projects. Assume that the internal rate of return
(IRR) of Project I and Project II is 18% and 15%, respectively.

a) Which project will you choose if you apply the NPV criterion? Why?
(5 marks)

b) Which project will you choose if you apply the payback criterion? Why?
(4 marks)

c) Which project will you choose if you apply the IRR criterion? Why?
(2 marks)

d) Based on the above answers, which project will you finally choose? Why?
(3 marks)

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Question 5 (18 marks)

Consider the following 2-stock portfolio:

Stock Investment Beta Standard Expected

Amount Deviation Return
X $100,000 1.2 10% 20%
Y $60,000 0.8 25% 12%

Assume that the risk-free rate is 5 percent and the expected return on the market
portfolio is 15 percent.

a) Using the CAPM or SML equation, compute the required rate of return of stock X
and stock Y.
(4 marks)

b) Are these stocks overpriced or underpriced? Briefly explain.

(6 marks)

c) Which stock has higher total risk? Why?

(2 marks)

d) Which stock has higher systematic risk? Why?

(2 marks)

e) Estimate the standard deviation of the following portfolio with equal amount of
capital invested in stock A and B:

State Probability Stock A Stock B

Boom 0.5 25% 0%
Bust 0.5 -15% 30%

(4 marks)

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Question 6 (12 marks)

Company E.T. is an Australian company with the following characteristics:

- Market value of debt: $150 million

- Number of shares outstanding: 4 million
- Share price: $50
- Beta: 1.8
- Most recent dividend: $1.5 per share; Dividends are expected to grow at 5% per
year indefinitely.
- Weighted average cost of capital (WACC): 6%
- Corporate tax rate: 40%

What is E.T.’s pre-tax cost of debt?

(12 marks)

END OF SECTION B

END OF PAPER