FINAL EXAM
LAHORE UNIVERSITY OF MANAGEMENT AND SCIENCES
PRINCIPALS OF FINANCE
Time allowed: 2 hours
Total Marks: 101
Student Name: ________________________ ID:
___________________________
Section: _____________
Answer ALL questions!
Check that you have 5 pages (including the cover page). The exam is
double-sided.
Leave your mobile phones at the front desk until you leave the examination
hall.
You may not leave the room once the quiz has started and then
return.
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Part A – MCQs (20 points)
1. The two major sources of short-term financing are
(a) a line of credit and accounts payable.
(b) accounts payable and accruals.
(c) a line of credit and accruals.
(d) accounts receivable and notes payable.
2. _________ are liabilities for services received for which payment has yet to be
made. The most common accounts are taxes and wages.
(a) Notes payable
(b) Accruals
(c) Accounts payable
(d) Accounts receivable
3. When a firm stretches accounts payable without hurting its credit rating, the
cost of foregoing the cash discount is
(a) reduced.
(b) increased.
(c) unaffected.
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(d) immaterial.
4. If a firm gives up the cash discount on goods purchased on credit, the firm
should pay the bill
(a) as late as possible.
(b) as soon as possible.
(c) before the credit period ends.
(d) on the last day of the credit period.
5. The prime rate of interest fluctuates with
(a) the changing supply and demand relationship for long-term funds.
(b) the changing supply and demand relationship for short-term funds.
(c) the risk of the firm borrowing the funds.
(d) demand in the bond market.
6. _________ effectively raises the interest cost to the borrower on a line of
credit.
(a) An operating change restriction
(b) An annual cleanup
(c) A compensating balance
(d) A commitment fee
7. A _________ guarantees the borrower that a specified amount of funds will be
available regardless of the tightness of money.
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(a) revolving credit agreement
(b) line of credit
(c) short-term self-liquidating loan
(d) single payment note
8. Compared to a line of credit, a revolving credit agreement generally will be
(a) a lower cost, higher risk method of short-term borrowing.
(b) a lower cost, lower risk method of short-term borrowing.
(c) a higher cost, higher risk method of short-term borrowing.
(d) a higher cost, lower risk method of short-term borrowing.
9. The interest rate charged on a secured short-term loan to a corporation is
typically _________ the interest rate on an unsecured loan.
(a) lower than
(b) the same as
(c) unrelated to
(d) higher than
10. Pledges of accounts receivable and factoring of accounts receivable
are made on _________ basis, respectively.
(a) a nonrecourse and a notification
(b) a nonnotification and a notification
(c) a notification and a recourse
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(d) a notification and a nonrecourse
11. The specific cost of each source of long-term financing is based on
_________ and _________ costs.
(a) before-tax; historical
(b) after-tax; historical
(c) before-tax; book value
(d) after-tax; current
12. When determining the after-tax cost of a bond, the face value of the
issue must be adjusted to the net proceeds amounts by considering
(a) the risk.
(b) the flotation costs.
(c) the approximate returns.
(d) the taxes.
13. Using the capital asset pricing model, the cost of common stock equity
is the return required by investors as compensation for
(a) the specific risk of the firm.
(b) the firm’s diversifiable risk.
(c) price volatility of the stock.
(d) the firm’s nondiversifiable risk.
14. In comparing the constant growth model and the capital asset pricing
model (CAPM) to calculate the cost of common stock equity,
(a) the constant growth model ignores risk, while the CAPM directly
considers risk as reflected in the beta.
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(b) the CAPM directly considers risk as reflected in the beta, while the
constant growth model uses the market price as a reflection of the
expected risk-return preference of investors.
(c) the CAPM directly considers risk as reflected in the beta, while the
constant growth model uses dividend expectations as a reflection of
risk.
(d) the CAPM indirectly considers risk as reflected in the market return,
while the constant growth model uses dividend expectations as a
reflection of risk.
15. Generally, the order of cost, from the least expensive to the most
expensive, for long-term capital of a corporation is
(a) new common stock, retained earnings, preferred stock, long-term
debt.
(b) common stock, preferred stock, long-term debt, short-term debt.
(c) preferred stock, retained earnings, common stock, new common stock.
(d) long-term debt, preferred stock, retained earnings, new common
stock.
16. When discussing weighing schemes for calculating the weighted
average cost of capital, the preferences can be stated as
(a) market value weights are preferred over book value weights and
target weights are preferred over historic weights.
(b) book value weights are preferred over market value weights and
target weights are preferred over historic weights.
(c) book value weights are preferred over market value weights and
historic weights are preferred over target weights.
(d) market value weights are preferred over book value weights and
historic weights are preferred over target weights.
17. Firms underprice new issues of common stock for the following
reason(s).
(a) When the market is in equilibrium, additional demand for shares can
be achieved only at a lower price.
(b) When additional shares are issued, each share’s percent of ownership
in the firm is diluted, thereby justifying a lower share value.
(c) Many investors view the issuance of additional shares as a signal that
management is using common stock equity financing because it
believes that the shares are currently overpriced.
(d) All of the above.
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18. The cost of retained earnings is
(a) zero.
(b) equal to the cost of a new issue of common stock.
(c) equal to the cost of common stock equity.
(d) irrelevant to the investment/financing decision.
19. A corporation has concluded that its financial risk premium is too high. In order to
decrease this, the firm can
(a) increase the proportion of long-term debt to decrease the cost of capital.
(b) increase short-term debt to decrease the cost of capital.
(c) decrease the proportion of common stock equity to decrease financial risk.
(d) increase the proportion of common stock equity to decrease financial risk.
20. The _________ is a weighted average of the cost of funds which reflects the
interrelationship of financing decisions.
(a) risk premium
(b) nominal cost
(c) cost of capital
(d) risk-free rate
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Part B – Numerical
Question 1 (7 points)
Zyra, a Canadian, invested in the common stock of IRC, a Turkish
corporation. She purchased 1,000 shares at 100.50 lira per share. Twelve
months later, she sold them at 150.75 lira per share. She received 20 Lira in
dividends at the end of twelve months.
Required
a. What was Zyra’s investment return (in percentage terms) for the year,
on the basis of the peso value of the shares?
b. The exchange rate for lira was 20 lira sper $1.00 at the time of the
purchase. At the time of the sale, the exchange rate was 23 liras per
$1.00. Translate the purchase and sale liras into Canadian $.
c. Calculate Zyra’s investment return on the basis of the Canadian $
value of the shares.
d. Explain why the two returns are different. Which one is more important
to Zyra?
Question 2 (14 points)
Assume that you can invest in any of the following three securities today.
You will hold them for
a year, however, there is uncertainty about how well your investments will
do over the ensuing
Assume that you can invest in any of the following three securities today.
You will hold them for
a year, however, there is uncertainty about how well your investments will
do over the ensuing
Assume that you can invest in any of the following three securities today.
You will hold them for
a year, however, there is uncertainty about how well your investments will
do over the ensuing
Assume that you can invest in any of the following three securities today. You
will hold them for a year, however, there is uncertainty about how well your
investments will do over the ensuing year. This uncertainty is represented by
the three “states of nature” that can potentially occur with probabilities of
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1/3, 1/3, 1/3. The returns for each security in the three states of nature are
give in the table below:
Required
a) Determine for both stocks A and B, expected return, variance, and
standard deviation. (8 points)
b) Assume that you invest 40% of your wealth in stock A and 60% of your
wealth in the
c) S&P 500. The expected return of your portfolio will be
d) The expected return and variance of your portfolio assuming that you
invest 40% of your wealth in stock A and 60% of your wealth in the S&P
500. (4 points)
e) When you calculate the variance of your portfolio, you should find that it
is less than the simple weighted average of the variances of the securities
in the portfolio, i.e. it should beless than (.40 * σ A2 + .60 * σS&P2). Can you
explain in words why you get this result? (2 points)
Question 3 (7 points)
Which payment option should a company select to obtain a patent given an
8% cost of capital:
a. A lump sum of $2,000,000 or six annual payments of $415,000?
b. How would this decision be affected if the annual payments were made
at the beginning of each year instead of the end?
c. What yearly payment would make the two offers identical in value at a
cost of capital of 9%?
d. Furthermore, considering projected after-tax cash inflows of $250,000
per year for 15 years, would this influence the firm’s decision on
financing the initial investment?
Question 4 (6 points)
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A tech startup is considering investing in a new software development
project. The initial investment for the project is $2,000,000, and it is
expected to generate cash flows of $800,000 per year for the next five years.
The company's cost of capital is 15%. However, the company estimates that
due to market uncertainties, there's a 30% chance that the project will fail
completely, resulting in no cash flows.
Required
a. Calculate the expected net present value (NPV) of the investment project
considering the probability of failure.
b. Determine the economic value added (EVA) for each year of the project's
life, considering the possibility of failure.
c. Discuss the implications of the uncertain outcome on the project's EVA and
how the company can mitigate risks associated with the investment decision.
Question 5 (14 points)
Star Warehouses has commissioned its financial manager to conduct a
meticulous assessment of the distinct costs associated with each form of
capital, as well as the intricacies involved in determining the weighted
average cost of capital (WACC).
Accommodating a tax rate of 30%, the complexities unfold as follows:
Debt: Star Warehouses contemplates the issuance of a 8-year, $1,000-par-
value bond, bearing a 10% coupon rate, currently valued at $990. The bond
issuance incurs a flotation cost equivalent to 2% of the par value, coupled
with a $10 discount per bond, adding layers of intricacy to its costing
dynamics.
Preferred Stock: Delving into preferred stock evaluation reveals an 6%
annual dividend yield, with a par value of $100 per share. The preferred
stock, available at a market price of $54 per share, imposes an additional
underwriting charge of $3 per share, contributing to the complexity of cost
assessment.
Common Stock: The valuation of common stock, trading at $40 per share,
explores into the anticipation of future dividends. With an expected dividend
payout of $8.87 per share by the end of 2020, a historical pattern of aligning
with 60% of earnings per share over the past 5 years underscores the
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intricate nature of predicting dividend distributions amidst market volatility
and economic uncertainties.
Additional information
Year Dividen
d
2019 4.62
2018 4.25
2017 3.95
2016 3.72
2015 3.25
Required
To entice potential buyers, the new common stock needs to be undervalued
by $5 per share, in addition to incurring $3 per share in flotation costs. The
anticipated dividend payments are projected to persist at 60% of earnings.
(Assume the required rate of return on equity equals the required rate of
return on debt. (Assume that rr = rs.)
a. Calculate the after-tax cost of debt. (5 points)
b. Calculate the cost of preferred stock. (2 points)
c. Calculate the cost of common stock. (4 points)
d. Calculate the WACC for Dillon Labs (Firm uses book value weights). (3
points)
Question 6 (28 points)
Sky labs, which has fixed operating costs of $325,000 and variable operating
costs equal to 45% of sales, has made the following three sales estimates,
with their probabilities noted. The firm wishes to analyze five possible capital
structures—0%, 20%, 30%, 40%, and 50% debt ratios. The firm’s total assets
of $1 million are assumed to be constant. Its common stock has a book value
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of $25 per share, and the firm is in the 40% tax bracket. The following
additional data have been gathered for use in analyzing the five capital
structures under consideration.
Additional information
Sales Probabi
lities
700,0 0.20
00
920,0 0.50
00
1,300, 0.30
000
Capital Before-tax Required
structure debt cost of debt, return, rs
ratio rd
0% 0% 10%
20% 8% 11%
30% 10% 12%
40% 13% 14%
50% 17% 20%
Required
a. Calculate the level of EBIT associated with each of the three levels of
sales. (3 points)
b. Calculate the amount of debt, the amount of equity, and the number of
shares of common stock outstanding for each of the five capital structures
being considered. (5 points)
c. Calculate the annual interest on the debt under each of the five capital
structures being considered. (Note: The before-tax cost of debt, rd, is the
interest rate applicable to all debt associated with the corresponding debt
ratio.) (2.5 points)
d. Calculate the EPS associated with each of the three levels of EBIT
calculated in part a for each of the five capital structures being
considered. (7.5 points)
e. Calculate the expected EPS, for each of the five capital structures, using
your findings in part d. (5 points)
f. Using the preferred stock valuation model and your findings in part e,
estimate the share value for each of the capital structures being
considered. (5 points)
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Question 7 (5 points)
Luxembourg Woodworks sells wooden tables. It reported total sales of
$2,180,000, with 70% of the sales on credit. It takes 50 days to collect
accounts receivable. The selling price is $30 per table while the variable cost
is $19 per table. The board is currently investigating a change in the
collection of accounts receivable that is expected to result in a 10% increase
in credit sales and a 10% increase in the average collection period. Bad
debts will also increase, from 2% to 5% of sales. The firm’s opportunity cost
on its investment in accounts receivable is 13%. (Note: Use a 365-day year.)
Required
a. Calculate bad debts in dollars for the current and proposed plans. (2
points)
b. Calculate the cost of the marginal bad debts to Luxembourg
Woodworks. (1 points)
c. Would you recommend the proposed plan? Explain. (1 points)
d. Under what circumstances would the decision to implement the
proposed plan change? (1 point)
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