AF208: FINANCIAL MANAGEMENT

FACULTY OF BUSINESS AND ECONOMICS/ SCHOOL OF ACCOUNTING AND FINANCE

Final Examination
Semester 2 2017

Face-to-Face Mode (F)

Duration of Exam: 3 hours + 10 minutes

Reading Time: 10 minutes

Writing Time: 3 hours

Instructions:

This test has a total mark of 100 and carries a 50% weighting towards your overall course grade

There are 21 pages in this test paper, including this cover page

You have 180 minutes to complete this paper and an additional 10 minutes reading time

Closed book examination

Answer ALL questions

You may use a hand-held, non-programmable calculator. This is not supplied.

SECTION A MULTIPLE CHOICE QUESTIONS 40 marks____

(SUGGESTED TIME ALLOCATION: 72 Minutes)

Circle the BEST answer for each of the following multiple-choice questions in the answer
grid provided in the answer booklet. Each multiple-choice question is worth one (1) mark.

1. Campbell Co. is trying to estimate its weighted average cost of capital (WACC). Which of the
following statements is most correct?

A. The after-tax cost of debt is generally cheaper than the after-tax cost of equity.
B. Since retained earnings are readily available, the cost of retained earnings is generally lower
than the cost of debt.
C. The after-tax cost of debt is generally more expensive than the before-tax cost of debt.
D. Statements A and C are correct.

2. Wyden Brothers has no retained earnings. The company uses the CAPM to calculate the cost of
equity capital. The company’s capital structure consists of common stock, preferred stock, and
debt. Which of the following events will reduce the company’s WACC?

A. A reduction in the market risk premium.

B. An increase in the flotation costs associated with issuing new common stock.
C. An increase in the company’s beta.
D. An increase in expected inflation.

3. Conglomerate Inc. consists of 2 divisions of equal size, and Conglomerate is 100 percent equity
financed. Division A’s cost of equity capital is 9.8 percent, while Division B’s cost of equity
capital is 14 percent. Conglomerate’s composite WACC is 11.9 percent. Assume that all
Division A projects have the same risk and that all Division B projects have the same risk.
However, the projects in Division A are not the same risk as those in Division B. Which of the
following projects should Conglomerate accept?

A. Division A project with an IRR an IRR 11 percent.

B. Division B project with an IRR of 12 percent.
C. Division B project with an IRR of 13 percent return.
D. Statements A and C are correct.

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4. Flaherty Electric has a capital structure that consists of 70 percent equity and 30 percent debt. The
company’s long-term bonds have a before-tax yield to maturity of 8.4 percent. Shareholders are
foreigners. Flaherty’s common stock currently trades at $40.5 per share. The year-end dividend
(D1) is expected to be $2.50 per share, and the dividend is expected to grow forever at a constant
rate of 7 percent a year. The company estimates that it will have to issue new common stock to
help fund this year’s projects. The company’s tax rate is 40 percent. What is the company’s
weighted average cost of capital, WACC?

A. 10.73%
B. 10.30%
C. 11.31%
D. 7.48%

5. For a typical firm, which of the following is correct? All rates are after taxes, and assume the
firm operates at its target capital structure. Note. d is for debt; e is for equity

A. rd > re > WACC.

B. re > rd > WACC.
C. WACC > re > rd.
D. re > WACC > rd.

6. You are contemplating purchasing a $1,000,000 181 day T-Bill that is selling at a discount of
4.25%. What is the dollar discount on the T-Bill?
A. $21,368.06
B. $42,500
C. $38,845.26
D. $19,367.51

7. Which of the following statements is most correct?

A. The NPV method assumes that cash flows will be reinvested at the cost of capital, while the IRR
method assumes reinvestment at the IRR.
B. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR
method assumes reinvestment at the IRR.
C. The NPV method assumes that cash flows will be reinvested at the cost of capital, while the IRR
method assumes reinvestment at the risk-free rate.
D. The NPV method does not consider the inflation premium.

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8. A major disadvantage of the payback period is that it

A. Is useless as a risk indicator.

B. Ignores cash flows beyond the payback period.
C. Does not directly account for the time value of money.
D. Statements b and c are correct.

9. The Seattle Corporation has been presented with an investment opportunity that will yield cash
flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and
$40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm’s cost of
capital is 10 percent. Assume cash flows occur evenly during the year, 1/365th each day. What
is the payback period for this investment?

A. 5.23 years
B. 4.86 years
C. 4.00 years
D. 6.12 years

10. A firm that moves from traditional inventory stocking methods to a just-in-time (JIT) system
should expect to see:

A. Reduced inventory levels

B. Funds released for alternative uses
C. Potentials for production halts
D. All of the above

11. What does it mean that firms should match maturities of their financing with the maturities
of the assets acquired with the funds from financing?

A. A firm should only borrow money to acquire assets that will be used by the firm for years
after the loan for the assets is repaid.
B. A firm should not borrow money to acquire assets that will be used by a subsidiary of the
firm that borrows the money.
C. A firm should not borrow money to acquire assets that will be used by a subsidiary of the
firm that borrows the money.
D. A firm should only borrow money to acquire assets which will produce income that can
specifically be used to repay the loan.

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12. Which is more important in financial planning for a multinational corporation (MNC), ex
ante financing cost or ex post financing cost?

A. Ex ante financing cost is more important since it is the projection of the financing cost.
B. Ex post financing cost is more important because it is the actual cost of financing.
C. Both are important in financial planning because they measure different costs.
D. Neither is important in financial planning because neither provide guidance in determining
which financing is best for an MNC.

13. A retail toy store (which is a proprietary company) places a large order for toys to be sold
during the lead-up to Christmas. The toys are delivered in mid-October for payment by 30
November. The store will have insufficient funds to pay the invoice until close of business
Christmas Eve. The store’s best course of action is to:

A. delay payment until the New Year

B. issue more shares to raise extra cash
C. lay-off staff to save on wages
D. arrange a short-term financing facility.
14. Which of the following assets is likely to have the highest loan-to-value ratio (LVR) as
security for short-term finance?

A. Vacant land in a non-residential area

B. New invoices
C. Existing trade receivables
D. All of the above

15. The concept of self-liquidation in regard to debt incorporates the notion that the cash:

A. inflows that result from the investments made with the debt funding will be received at
times when payments of interest are necessary
B. inflows that result from the investments made with the debt funding will be received at
times when repayments of principal are necessary
C. outflows that result from the investments made with the debt funding will occur at times
when receivables fall due for payment
D. None of the above.

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16. ABC Company receives trade credit for the purchase of $40000 worth of goods, marker
‘2/10, net 35’. The cost of forgoing the cash discount is:

A. 32%
B. 29.8%
C. 37.24%
D. None of the above

17. ‘Fungible’ means that:

A. a dollar in hand is worth more than a dollar in a cheque account

B. a dollar today is worth more than a dollar tomorrow
C. a dollar lost on a bet has greater value than a dollar won on a bet
D. any one dollar has the same value as any other dollar at a given point in time.

18. If demand for cars is 1300 per year and ordering and holding costs are $3000 and $4000
respectively, assuming a constant rate of demand this order would last:

A. 161 days
B. 12 days
C. 29 days
D. 83 days.

19. Given an economic order quantity (EOQ) of 120, demand of 100 000 units and holding
costs of $7, this implies ordering costs of approximately:

A. $12
B. $18
C. $7
D. $5

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20. Which of the following statements regarding Romalpa clauses is incorrect?

A. They ensure title to purchased goods does not pass to the buyer until the goods are fully paid
for.
B. Their purpose is to allow sellers to recover the goods if the buyer becomes insolvent.
C. Both a and b
D. None of the above

21. Which of the following is not a benefit of holding stocks?

A. Lower holding costs

B. Goodwill is built up
C. Cross sales are made and profits are increased
D. Sales are made and profits are gained

22. In a new share issue, whose role includes the following; advising on the terms of the new
share issue, buying the new issue and reselling it to the public?

A. Broker
B. Shareholders
C. Underwriter
D. The market

23. In a few cases, companies offer new shares to their existing shareholders through a
________ issue;
A. Option
B. Rights
C. Re-sell
D. None of the above

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24. Chelsea’s Classics Inc., a publicly-held firm, recently announced plans to raise new equity
funds for expansion. They will have a rights offering at a subscription price of $20 per share
with 10 rights necessary to buy each new share. The 1 million shares currently outstanding
are trading for $25 per share. How much new money will be raised through this offering?

A. $2.5 million
B. $5 million
C. $2 million
D. $25 million

25. Leverage Inc. has $100,000 of Capital including $30,000 of debt at an interest rate of 9
percent. If shareholders expect a return of 20 percent, what is the expected return on total
assets (ignore taxes)?

A. 14%
B. 16.7%
C. 3%
D. None of the above

26. Jasper Leper Books buys and sells second-hand paperback books. The manager needs to
reorganise the business’s finances from short-term to long-term debt. He decides to take out
an FDA for $50 000 at 7.5% p.a., compounded monthly over 4 years. He also agrees to
repay the loan on a fixed monthly schedule. What is the monthly payment?

A. $1,208.95
B. $$3,500
C. $4,166.67
D. None of the above

27. Sangeeta has just received a fully-franked dividend of $200 and he is currently at the 15%
personal income tax bracket. The current company tax rate is 30%. Find her after-tax
dividend income.

A. $242.85
B. $200
C. $85.71
D. None of the above

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28. Suppose a typical shareholder of Westpac Bank hold stocks for more than 12 months and
pay 45 cents of personal tax on each dollar of additional ordinary income. The company has
just announced a fully franked dividend of $1.50 per share. The company tax rate is 30%.
Westpac shares are currently selling at a cum-dividend price of $20 per share. Estimate the
ex-dividend price of CCB shares.

A. $20
B. $18.48
C. $17.50
D. None of the above

29. Which of the following statements is correct:

A. Dividend amounts are first determined, and the residual retained

B. In achieving the highest overall return, dividends are irrelevant
C. Most shareholders prefer retained earnings over dividends
D. There is conclusive proof that investors prefer dividends over retained earnings

30. Dividends may be considered relevant because:

A. They increase the investor's overall return

B. higher return will be earned than with retained earnings
C. they are preferred by investors in higher tax brackets
D. they resolve uncertainty in the minds of investors

31. By maintaining a relatively stable dividend level, the firm:

A. hopes to increase holdings of its common shares

B. hopes to decrease holdings of its common shares
C. hopes to increase the discount rate applied to future dividends
D. hopes to decrease the discount rate applied to future dividends

32. The directors of a small, closely held corporation may be reluctant to pay dividends at all
because:

A. the dividends will be taxed at a higher rate

B. they fear diluting the cash position of the firms
C. they haven't the means to do a complete funds flow analysis
D. they fear a shareholder proxy battle

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33. In chronological order, which of the following is correct:

A. ex-dividend date, holder of record date, payment date

B. holder of record date, ex-dividend date, holder of record date
C. payment date, ex-dividend date, holder of record date
D. holder of record date, payment date, ex-dividend date

34. If a firm repurchases its own stock:

A. in theory, the action is equivalent to paying cash dividends

B. the price of the stock is lowered into a more popular trading range
C. shareholders benefit less than with a stock split
D. shareholders benefit less than with a stock dividend

35. Which of the following is an argument for the relevance of dividends?

A. Information content
B. Reduction of uncertainty
C. Some investors’ preferences for current income
D. All of the above.

The following question refers to Questions 36, 37 and 38.

Beer Lake Equipment Company (BLEC) Commented [CT1]: page 308 multiple choice question

Beer Lake Equipment Company (BLEC) is considering an expansion which will require a new
machine that costs $125,000. BLEC can either lease or buy the equipment. The company’s tax
rate is 40% and its after tax cost of debt is 5%.
Lease
Annual payments of $26,400 made at the beginning of each year over five years. The lessor
covers all maintenance, while the lessee covers insurance and other costs. The lessee has the
option to purchase the machine for $31,250 paid along with the final lease payment.
Purchase
The $125,000 cost will be financed over five years with annual end of year payments of $31,580.
The machine will depreciated on the five year MACRS schedule and the firm will pay $3,500

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per year for a service contract to cover all maintenance. The company will cover all insurance
and other costs.
36. Refer to BLEC. What is the after-tax cash flow per year for the lease?
A. $26,400
B. $15,840
C. $10,560
D. $39,600
37. Refer to BLEC. What is the after tax cash flow for the first year from a purchase of the
machine? The depreciation rate under MACRS for year one is 20% and year two is 32%.
A. $31,583
B. $21,167
C. $19,515
D. $25,000
38. Refer to BLEC. What is the present value of the five years of after-tax cash flows from
purchasing the machine?

A. $92,504
B. $108,120
C. $77,351
D. $123,273

39. The cash flows associated with an investment project are as follows:
Cash flows
Year 1 $(70,000)
Year 2 $20,000
Year 3 $30,000
Year 4 $30,000
Year 5 $30,000
What is the payback period of the project? If a firm’s cutoff payback period is 3 years, should it
accept the project?

A. 2.7 years; reject the project

B. 2.7 years; accept the project
C. 3.6 years; reject the project
D. 3.6 years; accept the project

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40. When investors take a short position in one asset to invest more in another asset, they are
using:
A. Capital budgeting
B. Corporate leverage
C. Financial leverage
D. None of the above

Section B (30 marks)

(SUGGESTED TIME ALLOCATION: 54 Minutes)

Question 1 (8 marks)

After working for the past four years as a financial analyst for Nevada Power Corporation, you Commented [CT2]: page 414

receive a well-deserved promotion. You have been appointed to work on special projects for Mr.
Watkins, the chief financial officer (CFO). Your first assignment is to gather information on
dividend theory and policy, because the CFO wants to assess the firm’s current dividend policy.

Required:
1. Discuss the theory of dividend irrelevance. (4 marks)
2. How do taxes affect the dividend –irrelevance theory? (4 marks)

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Question 2 (10 marks) Commented [CT3]: page 460

Vinod Patel uses 80,000 units of an “A” item of raw material inventory each year. The firm
maintains level production throughout the year given the steady demand for its finished products.
The raw materials order cost is $225 per order and carrying costs are estimated to be 10.50 per
unit per year. The firm wants to maintain a safety stock of 10 days of inventory, and it takes 5
days for the firm to receive an order once it is placed. Assume a 365-day year.

Required:
1. Calculate the economic order quantity (EOQ) for Vinod Patel’s raw material. (3 marks)
2. How large a safety stock (in units) of inventory should the firm maintain? (4 marks)
Why is it important for the financial managers to understand the inventory control technique
used by production/operations managers? (1.5 marks)
3. How does controlling inventory impact a firm’s profitability? (1.5 marks)

Question 3 (12 marks)

Firm A’s capital Structure contains 20 percent debt and 80 percent equity. Firm B’s capital Commented [CT4]: page 292

structure contains 50 percent debt and 50percent equity. Both firms pay 7 percent annual interest
on their debt. The stock of Firm A ha a beta of 1.0, and the stock of Firm B has a beta of 1.375.
The risk-free rate of interest equals 4 percent, and the expected return on the market portfolio
equals 12 percent.

Required:

1. Calculate WACC for each firm, assuming there are no taxes (5 marks)
2. Recalculate WACC figures, assuming that the firms face a marginal tax rate of 34 percent.
(5 marks)
3. Explain which of the two companies benefited from tax. (2 marks)

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Section C (30 marks)
(SUGGESTED TIME ALLOCATION: 54 Minutes)

Speedy Auto Wash Ltd. is contemplating the purchase of a new high-speed washer to replace the Commented [CT5]: Page 257 of textMegginson

existing washer. The existing washer was purchased two years ago at an installed cost of
$120,000; it was being depreciated using the straight line method.

The existing washer is expected to have a useful life of five more years. The new washer costs
$210,000 and requires $10,000 in installation costs; it has a 5-year usable life and would be
depreciated using the straight line method. The existing washer can be sold for $140,000 without
incurring any removal or cleanup costs. To support the increased business resulting from
purchase of the new washer, accounts receivable would be increased by $80,000, inventories by
$60,000, and accounts payable by $116,000. At the end of five years, the existing washer is
expected to have a market value of zero; the new washer would be sold at net $58,000 after
removal and cleanup costs and before taxes. The firm pays taxes at a rate of 40 percent on both
ordinary income and capital gains. The estimated profits before depreciation and taxes over the
five years for both the new and the existing washer are shown in the following table:

Profits before Depreciation and Taxes

Year New Washer Existing Washer
1 $86,000 $52,000
2 $86,000 $52,000
3 $86,000 $52,000
4 $86,000 $52,000
5 $86,000 $52,000

The company uses the risk adjusted discount rate (RADR) to discount the project’s cash flows.
Classification by expenditure
Risk Category RADR %
Replacement 10
Expansion 12
New Products 15

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Required:
1. Calculate the initial cash outflow associated with the replacement of the existing washer
with the new one. (10 marks)
2. Determine the terminal cash flow expected at the end of year 5 from the proposed washer
replacement. (2.5 marks)
3. Determine the incremental cash flows associated with the proposed washer replacement
(10 marks)
4. Calculate the net present value and advise whether the existing washer should be changed.
(7.5 marks)

Show all relevant working

The End

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Formulae Sheet

F
NPb  kd, at = kd, bt (1 - t)
1 k  z , bt
n

( F  NPb )
I
k d ,bt  n n
CFt
( F  NPb ) NPV    IO
t 1 (1  k a )
t

n
Ct F D
NPb    k p , at 
t 1 1  rb  t
1  rb n NPp

D1 D1 (1  tc )
kre, at  g kre,bt  g
P0 P0

D1 D1 (1  t c )
ke,at  g ke,bt  g
NP NP

E ( R)  R f   ( E ( Rm )  R f )

D EAA= NPV
(1  tc ) PVFA
k p ,bt 
NPp

ARR= Average net profit Prime Cost Depreciation=Asset cost/ effective life
Average investment
WACC = Ʃ kx.wx
FS
P
(1  in )

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 2 DO
Q
H
Reorder point= (avg. daily units sales x delivery lead time) + safety stock
FVn  PV (1  k ) n N Pm  S 
RP 
N 1

PVAn  C 
 
 1  1  k  n 
 Px 
NPm  S
 k  N 1

 D   D   (1 - t p ) 
D t p   t c PCD - PXD  D  
1  tc  1  tc   (1  t c )(1  t g ) 

P  (1 - t p ) 
Current share price =    EPS PXD  PCD  D  
E  (1  tc )(1  t g ) 

free cash flow (1  g)

Value of the firm   cash balance
k-g

Free Cash Flow = after-tax operating income – reinvestment requirements

Total value accruing to existing shareholders  price per share  dividend per share

Dividend per share

Dividend payout ratio =
Earnings per share

PCD - PXD (1 - t p )
The dividend drop-off ratio is defined as 
D (1  t c )(1  t g )

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