AB1201

NANYANG TECHNOLOGICAL UNIVERSITY

SEMESTER 2 EXAMINATION 2021-2022

AB1201 - Financial Management

April 2022 Time Allowed: 2½ hours

INSTRUCTIONS

1 This paper contains SIX(6) questions and comprises FOUR(4) pages and ONE(1)
appendix of FIVE(5) pages.

2 Read the instructions for each question 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 FIVE(5) parts. Answer each part 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 part
is 20 lines (i.e., 2/3 of a page) in the answer booklet. Each part carries NINE(9) marks.

1a) Explain what Capital Asset Pricing Model (CAPM) is. In the context of CAPM, what
is “market risk”? How can a firm influence its market risk (i.e., its beta)? What are the
external factors that can affect a firm’s market risk? Elaborate your answers.

1b) Would two analysts applying the same Gordon Model (Dividend Discount Model) on
the same company arrive at the same intrinsic value for the shares of the company?
Explain your answer.

1c) Write down the general formula for Weighted Average Cost of Capital (WACC),
clearly define any notations used.

i) When computing WACC, should we use the current capital structure or the
target capital structure of the company? Should we use market values or book
values for the company’s debt and equity? Briefly explain why.
ii) In project appraisal, why should we adjust the WACC according to different
risk level of a project? How should the WACC be adjusted for a riskier project?

1d) What is the Weighted Average Cost of Capital (WACC) equation for a company which
does not issue preferred stock (you do NOT need to define the symbols used)?
Explain why, when the WACC of such a company is plotted against its debt/capital
ratio, it is likely to be a U-shape curve.

Explain how the cost of common equity changes with the level of debt used by the
company. Use the two appropriate equations that you have learnt in this module to
explain this effect and state the names of the two equations.

1e) Dividend policy of a company is the decision to either pay out annual earnings as cash
dividends to the shareholders or to retain them for internal uses. List and underline
THREE decisions relating to dividend policy that a company makes, and briefly explain
each of the three decisions.

(TOTAL: 45 marks)

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 AB1201
Section B

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

Question 2

Jane has taken a 10-year $100,000 floating interest mortgage loan with her bank. The loan
repayments are to be made at the end of every month. At the start of her mortgage, the monthly
repayment is computed based on an annual nominal loan interest rate of 6%, compounded
monthly, and the monthly repayment is calculated based on this interest rate. At the end of the
third year, the bank announces that the annual nominal loan interest rate is to be adjusted to
8%, compounded monthly. Therefore, the new monthly repayment needs to be re-calculated,
based on the remaining loan balance at the end of third year, using the new loan interest rate.
What is Jane’s new monthly repayment amount after the third year?

(TOTAL: 10 marks)
Question 3

You are considering investing $120,000 in a portfolio comprising 2 stocks: Bowin Inc. and
Doodle Corp. Bowin just paid a dividend of $0.60 per share, and its dividends are expected to
grow at a constant annual rate of 5%, perpetually. Doodle just paid a dividend of $0.48 per
share, and its dividends are expected to grow at a constant annual rate of 6.25%, perpetually.
The betas of Bowin’s and Doodle’s shares are 1.2 and 1.6, respectively. The market risk
premium is 5%, and the risk-free rate is 4%.

a) Which of the two stocks has a higher intrinsic value? And by how much (in $)?

(7 marks)

b) How much will you have to invest in each stock to achieve a portfolio beta of
1.35?
(3 marks)

(TOTAL: 10 marks)

Question 4

Today, an investor buys a 10-year annual coupon bond with a par value of $1,000 which has a
coupon rate of 3%. Its yield to maturity is currently X%. The investor plans to hold the bond
for 3 years and expects to earn a realized yield of 15% per annum if he sells the bond for $1,200
at the end of year 3. Calculate the value of X?

(TOTAL: 10 marks)

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 AB1201
Question 5

a) Six years ago, a company had 20 million shares and each share was traded at $30. Since
then, the company has declared and paid a X% stock dividend and has also carried out
a 3-for-2 stock split. Furthermore, due to business growth over the years, the company’s
current market capitalization is 80% higher than it was six years ago. If the current
market price of the company’s shares is $32, what was the percentage of stock dividend
the company distributed (i.e., what is the value of X)?

(9 marks)

b) A company has two types of bonds, 6-year bonds and 10-year bonds. The yield of the
6-year bonds is 10.5%. The real risk-free rate is 2.5%. The maturity risk premium is
0.1(t – 1)%, where t is the number of years to maturity. The sum of the default risk
premium and liquidity premium is the same for both bonds. The annual inflation for the
first 3 years is 3%, and thereafter 4% annually. What should be the yield of the
company’s 10-year bonds?

(6 marks)

(TOTAL: 15 marks)

Question 6

ABC Limited is considering buying an equipment, but the company’s management wants you
to perform some capital budgeting analysis to show them whether there is a net advantage to
leasing the equipment instead. You are provided with the following information:

The equipment will cost $1,000,000.

Depreciation of the equipment will be based on MACRS 3-year class. Therefore, the
depreciation rates for Years 1 to 4 are 33%, 45%, 15%, and 7%, respectively.
This “project” is expected to last three years and at the end of the three years, the equipment
has an expected selling price of $100,000.
The company can contract out the maintenance cost of the equipment, which will cost the
company $50,000 a year, payable at the beginning of every year.
The company is in the 20% tax bracket.
For financing this purchase, the company could obtain a 3-year simple-interest loan, with
interest payable at the end of the year, at a before-tax interest cost of 8% per annum.
The company’s weighted average cost of capital is 12%.
If the company were to lease the equipment, the leasing cost would be $400,000 per year, for
three years, payable at the beginning of every year. Maintenance is included in the lease.

With all the above information, analyse the two alternatives (i.e., Lease and Buy) for securing
the equipment. Present your analysis in a table format, with “Items” in column 1, “Year 0 ($)”
in column 2, “Year 1 ($)” in column 3, “Year 2 ($)” in column 4, and “Year 3 ($) in column 5.
Based on your analysis, explain whether the company should lease or buy the equipment?

(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
Future value  FV N  P V (1  I) N
FV N
Present value  PV 
(1  I) N
 (1+I)N -1
FVAN =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 6

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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-bond  rt*  IPt  MRPt

rC-bond  rt*  IPt  M RPt  DRPt  LPt

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 ˆri
i=1

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

RPM = rM - rRF
RPi  (RPM )b i

ri  rR F  (rM  rR 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 7

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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 0 1  g  D 1  g 
1 2 

Constant growth stock: Pˆ 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 8

7
 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
t
N
COFt TV
MIRR :   t 0
, PV costs 
1  r  1  MIRR  1  MIRR 
t N N
t 0

Note: Appendix 1 continues on page 9

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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 -