AB1201

NANYANG TECHNOLOGICAL UNIVERSITY

SEMESTER 1 EXAMINATION 2022-2023

AB1201 - Financial Management

November 2022 Time Allowed: 2.5 hours

INSTRUCTIONS

1 This paper contains SIX(6) questions and comprises FIVE(5) pages and ONE(1)
appendix of FIVE(5) pages.

2 The questions are divided into three sections. Read the instructions for each section
carefully.

3 Answer ALL questions.

4 The number of marks allocated is shown at the end of each question.

5 Write your answer to each question in the answer booklet.

6 Answers will be graded for content and appropriate presentation, and compliance with
instructions.

Note: Exam Questions begin on Page 2.

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 AB1201
Section A

Question 1

INSTRUCTION: This short-essay question consists of FOUR(4) sub-questions. Answer each

sub-question in a clear and organized paragraph. Explain your answers by including arguments
or examples, where appropriate, to support or illustrate your answers. Use complete sentences.
It is important that you write LEGIBLY. The maximum length for your answer for each
sub-question is 20 lines (i.e., 2/3 of a page) in the answer booklet. Each sub-question carries
TEN(10) marks.

1a) Assume you have two options to receive money: Plan A will pay you $X annually for
10 years, while Plan B will pay you $Y annually and perpetually. Both plans have the
same risk, and also have the same present value at r%, which is the annual rate you can
earn with the money you receive.

Briefly comment on each of the following two statements:

i) It is better for you to choose Plan B because the future value of Plan B is
infinitely large compared to that of Plan A.
ii) If r% increases, it will make Plan A more attractive to you.

1b) i) Describe the firm-specific risk and the systemic risk associated with a single-
stock investment and provide an example for each of these risks.
ii) Explain why a portfolio’s stand-alone risk will not decline to zero even when
we increase the number of stocks in the portfolio by randomly adding one stock
at a time.

1c) Briefly define each of the following:

i) Stock Market Equilibrium
ii) Stock Market Efficiency

List three possible implications of an efficient stock market.

1d) i) Briefly explain NPV profile. What are the two possible factors that cause NPV
profiles of two projects to cross?
ii) In capital budgeting analysis, do the IRR and NPV methods always lead to the
same accept/reject decision? Explain. List 2 reasons why NPV is better than
IRR method.

(TOTAL: 40 marks)

Note: SECTION B (Question 2) is on page 3

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 AB1201
Section B

Question 2

INSTRUCTION: This question consists of FIVE(5) sub-questions. In the answer booklet,

write ONLY THE FINAL NUMERICAL ANSWER for each sub-question. Answer all five
sub-questions IN ONE PAGE. NO WORKINGS NEED TO BE SHOWN (i.e., workings
will not be graded). Each sub-question carries THREE(3) marks.

a) You have a portfolio consisting of stock A, stock B and stock C, which have expected
returns of 4%, 8% and 12%, respectively. Given that you have 30% of your money
invested in stock B, and the amount invested in stock A is thrice that invested in stock
C, what is your portfolio’s expected return?

b) An amount of $100 will be deposited into your bank account every year, with the first
deposit made starting today. The annual deposits will continue perpetually. If your bank
account earns a nominal interest rate of 2% per annum, compounded annually, how
much is this stream of infinite deposits worth to you today?

c) Benston Corporation has a target capital structure of 40% debt and 60% equity. It has
no preferred stock. The company’s before-tax cost of debt is 10% and its marginal tax
rate is 20%. Its current stock price is $21 and the last dividend, D0, was $2 per share.
Subsequent annual dividends are expected to grow at a rate of 5% per year, perpetually.
What is the company’s weighted average cost of capital (WACC)?

d) Company ABZ is considering investing $X in a 4-year project. The project is expected

to provide future cash inflows of $10,000, $15,000, $30,000, and $40,000 at the end of
Years 1, 2, 3 and 4, respectively. The interim cash flows are reinvested at an annual rate
of 10%. If the project’s MIRR is 14.25%, what is the investment cost of this project
(i.e., what is $X)? (Express your answer to the nearest dollar.)

e) Tell Me More Inc.’s capital structure consists of debt and common equity. Its current
capital structure consists of 20% debt. Its new CFO is considering changing the current
capital structure to 40% debt by issuing additional bonds and using the proceeds to
repurchase some of the company’s common shares. After recapitalization, the
company’s cost of equity is expected to be 16.04%. If the risk-free rate is 5%, market
risk premium is 6%, and the company’s marginal tax rate is 20%, what is the company’s
current levered beta (before recapitalization)?

(TOTAL: 15 marks)

Note: SECTION C (Question 3) is on page 4

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 AB1201
Section C

INSTRUCTION: Begin your answer to each question on a separate page of the answer booklet.
Show appropriate workings for all questions.

Question 3

A sum of money is deposited into an account at the end of every month. In the first year, the
monthly deposits will be $1,000, which will be increased by 5% annually for subsequent years
(i.e., monthly deposits will be $1,050 in the second year, $1,102.50 in the third year, and so
on). The account earns an annual nominal interest rate of 10%, with daily compounding
(assume 30 days in a month, and 360 days in a year.)

a) What amount of money will the account have at the end of the first year?

(5 marks)

b) Assuming the pattern of deposits continues perpetually, what is the present value of this
infinite series of deposits?

(10 marks)

(TOTAL: 15 marks)

Question 4

a) Bond XYZ is a 3-year, annual coupon bond with a par value of $1,000. The bond’s
stated annual coupon rate is 9%. You have bought the bond today at the market price
of $990. Suppose you are only able to achieve a reinvestment rate of 3% per annum
when you re-invest the bond’s coupon payments in the future due to a sharp decline in
market interest rate after you bought the bond. What will be your actual total rate of
return per annum if you hold the bond to maturity?

(5 marks)

b) SBL Limited recently paid a dividend of $1 per share, and the dividend is expected to
grow at a constant annual rate of 3% per year, perpetually. The beta of the company's
stock is 1.2, the market risk premium is 5.5%, and the risk-free rate is 4%. The
company’s current market share price is $20. What is your expected total rate of
return if you purchase the company’s share at its current market price (assume a one-
year investment horizon)?

(5 marks)

(TOTAL: 10 marks)

Note: Question 5 is on page 5

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 AB1201
Question 5

Company XYZ is currently using a machine that was purchased 3 years ago. It expects the
machine to last for another 5 years. The cost of the machine was $640,000 at the time of
purchase, and the company applies straight-line depreciation on the machine over 8 years. At
the end of the 8 years, the machine will have zero salvage value.

The current machine can produce 10,000 units of product per annum with a variable cost of
$10 per unit and an overall fixed cost of $14,000 per year. The company is able to sell all the
produced units at a price of $30 per unit.

The company is now considering replacing the current machine with a new one. The current
machine can be sold now for $410,000. The cost of the new machine is $500,000 and it is
expected to last for 5 years. The company will apply straight-line depreciation on the new
machine over 5 years. The new machine will have zero salvage value at the end of 5 years.

The new machine can produce 15,000 units of product per annum, with variable cost of $8 per
unit and an overall fixed cost of $15,000 per year. There is no change in the sale price per unit.

Calculate the net present value of the machine replacement project and determine whether
Company XYZ should replace its current machine, given that its corporate tax rate is 30% and
its required rate of return for the project is 10%.

(TOTAL: 10 marks)

Question 6

Mr Vance bought Montana Corp’s common shares last year at a price of $80 per share. The
company has just completed a 5-for-3 stock split this year. Since the stock split, the firm's
market capitalization has also increased by 5% as a result of increased liquidity of its shares
and favourable signalling effects. The company expects to pay annual dividends per share of
$1.20 and $1.35, respectively in the coming two years, thereafter dividends are expected to
grow at an annual rate of 6%, perpetually. The stock’s required rate of return is 12%. If Mr
Vance wants to sell his shares 3 years from now (i.e., at the end of Year 3) and expects to
achieve 10% annual rate of return, how much should he sell his shares for?

(TOTAL: 10 marks)

- END OF PAPER –

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 AB1201
Appendix 1
Selected Formulas

Chapter 3
Stockholders' equity  Paid-in capital  Retained earnings

Stockholders' equity  Total assets  Total liabilities

Net working capital = Current assets - Current liabilities

Net operating working capital
= (Current assets – Excess cash) – (Current liabilities – Notes payable)
* Note on NOWC, assume Excess cash = 0

Operating income (or EBIT)  Sales revenue  Operating costs

FCF = [EBIT(1-T) + Depreciation] – (Capital expenditures + ∆Net operating working

capital)
Chapter 5
F u t u r e v a lu e  F V N  P V (1  I ) N
FV N
Present value  PV 
(1  I) N
 (1+I) N -1
FVA N =PMT(1+I) N-1 +PMT(1+I) N-2 +PMT(1+I) N-3 +...+PMT(1+I)0 = PMT  
 I 
FVAdue  FVAordinary 1  I 
 1 
 1- 
PMT PMT PMT (1+I) N
PVA N = + +...+ = PMT  
 
1 2 N
(1+I) (1+I) (1+I) I
 

PVAdue  PVAordinary 1  I 

PMT
PV of a perpetuity 
I
N
CF1 CF2 CFN CFt
PV   L 
1  I  1  I  1  I  1  I 
1 2 N t
t 1

Stated annual rate I

Periodic rate  I PER   
Number of payments per year M

Number of periods = (Number of years)(Periods per year) = N×M

M
 I 
Effective annual rate  EFF%   1  NOM   1.0
 M 

Note: Appendix 1 continues on page 7

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 AB1201
Appendix 1 (continued)

Chapter 7
Quoted interest rate (r)  r*  IP  DRP  LP  MRP
 rRF  DRP  LP  MRP

rT-bill  rRF  r*  IP
rT -b o n d  rt*  IP t  M R P t

rC -b o n d  r t*  IP t  M R P t  D R P t  L P t

Chapter 8
N
ˆ = P1 r1  P2 r2  ...  PN rN =  Pi ri
Expected rate of return (r)
i=1

N
Standard deviation    (r  r)ˆ P
i 1
i
2
i

N
rˆp = w 1 rˆ1  w 2 rˆ2  ...  w N rˆN =  w i rˆi
i=1

N
b p = w 1 b1 +w 2 b 2 +...+w N b N =  w i b i
i=1

RPM = rM - rRF
RPi  (RPM )b i

ri  r R F  ( r M  r R F ) b i

Chapter 9
INT INT INT M
Bond 's value  VB    L  
1  rd  1  rd  1  rd  1  rd 
1 2 N N

N
INT M
  
1  rd  1  rd 
t N
t 1

2N
INT 2 M
Price of semiannual-coupon bond (VB )   
1  rd 2 1  rd 2
t 2N
t 1

Note: Appendix 1 continues on page 8

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 AB1201
Appendix 1 (continued)

Chapter 10
 
Value of stock Pˆ0  PVof expected future dividends
D1 D2 D
  L
1  rs  1  rs  1  rs 
1 2 


Dt

1  rs 
t
t 1

D 1  g  D 1  g  D 1  g 
1 2 

Constant growth stock: Pˆ 0  0  0 L  0

1  rs  1  rs  1  rs 
1 2 

D 0 1  g  D1
 
rs  g rs  g

Expected rate Expected Expected grow th rate, or

 
of return dividend yield capital gains yield

D
Horizon value  Pˆ N  N+1
rs  g

D1
r̂s  g
P0
Growth rate = (1-Payout ratio)ROE

Return on common equity (ROE) = Net Income/Common Equity

Payout ratio = Dividends/ Net Income
Retention ratio = 1 – Payout ratio
D
Zero growth stock: Pˆ 0 
rs
D1 D2 DN D N 1 D
Nonconstant growth stock : Pˆ 0   L  L 
1  rs  1  rs  1  rs  1  rs  1  rs 
1 2 N N 1 

D1 D2 DN Pˆ N
  L 
1  rs  1  rs  1  rs  1  rs 
1 2 N N

 PV of nonconstant dividends  PV of horizon value, Pˆ N

Price/Earnings (P/E) = Price per share/ Earnings per share

Dp Dp
Vp  r̂p 
rp Vp

Note: Appendix 1 continues on page 9

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 AB1201
Appendix 1 (continued)

Chapter 11
 %  After-tax   % of  Cost of   % of  Cost of 
        
WACC   of  cost of    preferred  preferred    common  common 
 debt  debt   stock  stock   equity  equity 
        
 w d rd 1  T   w p rp  w c rs
After-tax cost of debt  Interest rate on new debt  Tax savings
 rd  rd T
 rd 1  T 

Dp
Component cost of preferred stock  rp 
Pp

Required rate of return  Expected rate of return

D1
rs  rRF  RP   g  rˆs
P0

rs  rRF   RPM  bi
 rRF   rM  rRF  bi

D1
rs  rˆs   Expected g
P0

D1
Cost of equity from new stock  re  g
P0 1  F

Chapter 12
N
CF1 CF2 CFN CFt
NPV= CF0 + 1
+
(1+r) (1+r) 2
+...+
(1+r) N
=  (1+r)
t=0
t

Unrecovered cost
Number of
at start of year
Payback  years prior to 
Cash flow during
full recovery
full recovery year

CF1 CF2 CFN

IRR: CF0   L  0
1  IRR  1  IRR  1  IRR 
1 2 N

N
CFt
 0
1  IRR 
t
t0

 CIF 1  r 
Nt
N t
COFt TV
MIRR :   t 0
, PV costs 
1  r  1  MIRR  1  MIRR 
t N N
t 0

Note: Appendix 1 continues on page 10

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 AB1201
Appendix 1 (continued)

Chapter 13
Operating cash flows = EBIT (1-T) + Depreciation and Amortization
Taxes paid on salvaged assets = Tax rate x (Salvage value – Book value)

Chapter 15

[EBIT(1-T)]
ROIC=
Total invested capital
Operating breakeven: EBIT = PQ – VQ – F = 0
Debt-to-capital ratio = Debt/Capital = Debt/ (Debt + Equity)
Debt-to-equity ratio = Debt/Equity
bL  bU 1  1  T D E 

bL
bU 
1  1  T  D E 

- END OF APPENDIX 1 -

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