For a price of $100, Vera will sell you a 2 year bond paying semi-annual coupons of 10% pa. The face value of the bond is $100. Other bonds with similar risk, maturity and coupon characteristics trade at a yield of 8% pa.

Your friend wants to borrow $1,000 and offers to pay you back $100 in 6 months, with more $100 payments at the end of every month for another 11 months. So there will be twelve $100 payments in total. She says that 12 payments of $100 equals $1,200 so she's being generous.

If interest rates are 12% pa, given as an APR compounding monthly, what is the Net Present Value (NPV) of your friend's deal?

**Question 22** NPV, perpetuity with growth, effective rate, effective rate conversion

What is the NPV of the following series of cash flows when the discount rate is 10% given as an effective annual rate?

The first payment of $90 is in 3 years, followed by payments every 6 months in perpetuity after that which shrink by 3% every 6 months. That is, the growth rate every 6 months is actually negative 3%, given as an effective 6 month rate. So the payment at ## t=3.5 ## years will be ## 90(1-0.03)^1=87.3 ##, and so on.

**Question 24** implicit interest rate in wholesale credit, effective rate

A bathroom and plumbing supplies shop offers credit to its customers. Customers are given 60 days to pay for their goods, but if they pay within 7 days they will get a 2% discount.

What is the effective interest rate implicit in the discount being offered? Assume 365 days in a year and that all customers pay on either the 7th day or the 60th day. All rates given in this question are effective annual rates.

**Question 31** DDM, perpetuity with growth, effective rate conversion

What is the NPV of the following series of cash flows when the discount rate is **5**% given as an effective **annual** rate?

The first payment of $10 is in 4 years, followed by payments every 6 months forever after that which shrink by 2% every 6 months. That is, the growth rate every 6 months is actually **negative 2%**, given as an effective **6 month** rate. So the payment at ## t=4.5 ## years will be ## 10(1-0.02)^1=9.80 ##, and so on.

If a project's net present value (NPV) is zero, then its internal rate of return (IRR) will be:

A stock pays annual dividends which are expected to continue forever. It just paid a dividend of $10. The growth rate in the dividend is 2% pa. You estimate that the stock's required return is 10% pa. Both the discount rate and growth rate are given as effective annual rates. Using the dividend discount model, what will be the share price?

A stock is expected to pay the following dividends:

Cash Flows of a Stock | ||||||

Time (yrs) | 0 | 1 | 2 | 3 | 4 | ... |

Dividend ($) | 0.00 | 1.00 | 1.05 | 1.10 | 1.15 | ... |

After year 4, the annual dividend will grow in perpetuity at 5% pa, so;

- the dividend at t=5 will be $1.15(1+0.05),
- the dividend at t=6 will be $1.15(1+0.05)^2, and so on.

The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates. What is the current price of the stock?

The following is the Dividend Discount Model (DDM) used to price stocks:

### P_0 = \frac{d_1}{r-g} ###Assume that the assumptions of the DDM hold and that the time period is measured in years.

Which of the following is equal to the expected dividend in 3 years, ## d_3 ##?

The required return of a project is 10%, given as an effective annual rate. Assume that the cash flows shown in the table are paid all at once at the given point in time.

What is the Profitability Index (PI) of the project?

Project Cash Flows | |

Time (yrs) | Cash flow ($) |

0 | -100 |

1 | 0 |

2 | 121 |

The phone company Telstra have 2 mobile service plans on offer which both have the same amount of phone call, text message and internet data credit. Both plans have a contract length of 24 months and the monthly cost is payable in advance. The only difference between the two plans is that one is a:

- 'Bring Your Own' (BYO) mobile service plan, costing $50 per month. There is no phone included in this plan. The other plan is a:
- 'Bundled' mobile service plan that comes with the latest smart phone, costing $71 per month. This plan includes the latest smart phone.

Neither plan has any additional payments at the start or end.

The only difference between the plans is the phone, so what is the implied cost of the phone as a present value?

Assume that the discount rate is 2% per month given as an effective monthly rate, the same high interest rate on credit cards.

**Question 48** IRR, NPV, bond pricing, premium par and discount bonds, market efficiency

The theory of fixed interest bond pricing is an application of the theory of Net Present Value (NPV). Also, a 'fairly priced' asset is not over- or under-priced. Buying or selling a fairly priced asset has an NPV of zero.

Considering this, which of the following statements is **NOT** correct?

**Question 65** annuity with growth, needs refinement

Which of the below formulas gives the present value of an annuity with growth?

**Hint**: The equation of a perpetuity without growth is: ###V_\text{0, perp without growth} = \frac{C_\text{1}}{r}###

The formula for the present value of an annuity without growth is derived from the formula for a perpetuity without growth.

The idea is than an annuity with T payments from t=1 to T inclusive is equivalent to a perpetuity starting at t=1 with fixed positive cash flows, plus a perpetuity starting T periods later (t=T+1) with fixed negative cash flows. The positive and negative cash flows after time period T cancel each other out, leaving the positive cash flows between t=1 to T, which is the annuity.

###\begin{aligned} V_\text{0, annuity} &= V_\text{0, perp without growth from t=1} - V_\text{0, perp without growth from t=T+1} \\ &= \dfrac{C_\text{1}}{r} - \dfrac{ \left( \dfrac{C_\text{T+1}}{r} \right) }{(1+r)^T} \\ &= \dfrac{C_\text{1}}{r} - \dfrac{ \left( \dfrac{C_\text{1}}{r} \right) }{(1+r)^T} \\ &= \dfrac{C_\text{1}}{r}\left(1 - \dfrac{1}{(1+r)^T}\right) \\ \end{aligned}###

The equation of a perpetuity with growth is:

###V_\text{0, perp with growth} = \dfrac{C_\text{1}}{r-g}###**Question 56** income and capital returns, bond pricing, premium par and discount bonds

Which of the following statements about risk free government bonds is **NOT** correct?

**Hint:** Total return can be broken into income and capital returns as follows:

###\begin{aligned} r_\text{total} &= \frac{c_1}{p_0} + \frac{p_1-p_0}{p_0} \\ &= r_\text{income} + r_\text{capital} \end{aligned} ###

The capital return is the growth rate of the price.

The income return is the periodic cash flow. For a bond this is the coupon payment.

You just borrowed $400,000 in the form of a 25 year **interest-only** mortgage with monthly payments of $3,000 per month. The interest rate is 9% pa which is not expected to change.

You actually plan to pay more than the required interest payment. You plan to pay $3,300 in mortgage payments every month, which your mortgage lender allows. These extra payments will reduce the principal and the minimum interest payment required each month.

At the maturity of the mortgage, what will be the principal? That is, after the last (300th) interest payment of $3,300 in 25 years, how much will be owing on the mortgage?

**Question 58** NPV, inflation, real and nominal returns and cash flows, Annuity

A project to build a toll bridge will take two years to complete, costing three payments of $100 million at the start of each year for the next three years, that is at t=0, 1 and 2.

After completion, the toll bridge will yield a constant $50 million at the end of each year for the next 10 years. So the first payment will be at t=3 and the last at t=12. After the last payment at t=12, the bridge will be given to the government.

The required return of the project is 21% pa given as an effective annual **nominal** rate.

All cash flows are **real** and the expected inflation rate is 10% pa given as an effective annual rate. Ignore taxes.

The Net Present Value is:

The theory of fixed interest bond pricing is an application of the theory of Net Present Value (NPV). Also, a 'fairly priced' asset is not over- or under-priced. Buying or selling a fairly priced asset has an NPV of zero.

Considering this, which of the following statements is **NOT** correct?

**Question 69** interest tax shield, capital structure, leverage, WACC

Which statement about risk, required return and capital structure is the most correct?

Stock A has a beta of 0.5 and stock B has a beta of 1. Which statement is **NOT** correct?

The equations for Net Income (NI, also known as Earnings or Net Profit After Tax) and Cash Flow From Assets (CFFA, also known as Free Cash Flow to the Firm) per year are:

###NI=(Rev-COGS-FC-Depr-IntExp).(1-t_c)###

###CFFA=NI+Depr-CapEx - \varDelta NWC+IntExp###

For a firm with debt, what is the amount of the interest tax shield per year?

A company has:

- 50 million shares outstanding.
- The market price of one share is currently $6.
- The risk-free rate is 5% and the market return is 10%.
- Market analysts believe that the company's ordinary shares have a beta of
**2**. - The company has 1 million preferred stock which have a face (or par) value of $100 and pay a constant dividend of 10% of par. They currently trade for $80 each.
- The company's debentures are publicly traded and their market price is equal to 90% of their face value.
- The debentures have a total face value of $60,000,000 and the current yield to maturity of corporate debentures is 10% per annum. The corporate tax rate is 30%.

What is the company's after-tax weighted average cost of capital (WACC)? Assume a classical tax system.

Portfolio Details | ||||||

Stock | Expected return |
Standard deviation |
Correlation | Dollars invested |
||

A | 0.1 | 0.4 | 0.5 | 60 | ||

B | 0.2 | 0.6 | 140 | |||

What is the expected return of the above portfolio?

Which statement(s) are correct?

(i) All stocks that plot on the Security Market Line (SML) are fairly priced.

(ii) All stocks that plot above the Security Market Line (SML) are overpriced.

(iii) All fairly priced stocks that plot on the Capital Market Line (CML) have zero idiosyncratic risk.

Select the most correct response:

A stock's correlation with the market portfolio increases while its total risk is unchanged. What will happen to the stock's expected return and systematic risk?

Your friend just bought a house for $400,000. He financed it using a $320,000 mortgage loan and a deposit of $80,000.

In the context of residential housing and mortgages, the 'equity' tied up in the value of a person's house is the value of the house less the value of the mortgage. So the initial equity your friend has in his house is $80,000. Let this amount be E, let the value of the mortgage be D and the value of the house be V. So ##V=D+E##.

If house prices suddenly fall by **10**%, what would be your friend's percentage change in equity (E)? Assume that the value of the mortgage is unchanged and that no income (rent) was received from the house during the short time over which house prices fell.

Remember:

### r_{0\rightarrow1}=\frac{p_1-p_0+c_1}{p_0} ###

where ##r_{0-1}## is the return (percentage change) of an asset with price ##p_0## initially, ##p_1## one period later, and paying a cash flow of ##c_1## at time ##t=1##.

An established mining firm announces that it expects large losses over the following year due to flooding which has temporarily stalled production at its mines. Which statement(s) are correct?

(i) If the firm adheres to a full dividend payout policy it will not pay any dividends over the following year.

(ii) If the firm wants to signal that the loss is temporary it will maintain the same level of dividends. It can do this so long as it has enough retained profits.

(iii) By law, the firm will be unable to pay a dividend over the following year because it cannot pay a dividend when it makes a loss.

Select the most correct response:

A company runs a number of slaughterhouses which supply hamburger meat to McDonalds. The company is afraid that live cattle prices will increase over the next year, even though there is widespread belief in the market that they will be stable. What can the company do to hedge against the risk of increasing live cattle prices? Which statement(s) are correct?

(i) buy call options on live cattle.

(ii) buy put options on live cattle.

(iii) sell call options on live cattle.

Select the most correct response:

Below are 4 option graphs. Note that the y-axis is payoff at maturity (T). What options do they depict? List them in the order that they are numbered.

All things remaining equal, the variance of a portfolio of two positively-weighted stocks **rises** as:

The US firm Google operates in the online advertising business. In 2011 Google bought Motorola Mobility which manufactures mobile phones.

Assume the following:

- Google had a 10% after-tax weighted average cost of capital (WACC) before it bought Motorola.
- Motorola had a 20% after-tax WACC before it merged with Google.
- Google and Motorola have the same level of gearing.
- Both companies operate in a classical tax system.

You are a manager at Motorola. You must value a project for making mobile phones. Which method(s) will give the correct valuation of the mobile phone manufacturing project? Select the most correct answer.

The mobile phone manufacturing project's:

A firm changes its capital structure by issuing a large amount of equity and using the funds to repay debt. Its assets are unchanged. Ignore interest tax shields.

According to the Capital Asset Pricing Model (CAPM), which statement is correct?

You have just sold an 'in the money' 6 month European put option on the mining company BHP at an exercise price of $40 for a premium of $3.

Which of the following statements best describes your situation?

What is the Internal Rate of Return (IRR) of the project detailed in the table below?

Assume that the cash flows shown in the table are paid all at once at the given point in time. All answers are given as effective annual rates.

Project Cash Flows | |

Time (yrs) | Cash flow ($) |

0 | -100 |

1 | 0 |

2 | 121 |

Your credit card shows a $600 debt liability. The interest rate is 24% pa, payable monthly. You can't pay any of the debt off, except in 6 months when it's your birthday and you'll receive $50 which you'll use to pay off the credit card. If that is your only repayment, how much will the credit card debt liability be one year from now?

The following cash flows are expected:

- 10 yearly payments of $60, with the first payment in 3 years from now (first payment at t=3).
- 1 payment of $400 in 5 years and 6 months (t=5.5) from now.

What is the NPV of the cash flows if the discount rate is 10% given as an effective annual rate?

You're trying to save enough money to buy your first car which costs $2,500. You can save $100 at the end of each month starting from now. You currently have no money at all. You just opened a bank account with an interest rate of 6% pa payable monthly.

How many months will it take to save enough money to buy the car? Assume that the price of the car will stay the same over time.

A text book publisher is thinking of asking some teachers to write a new textbook at a cost of $100,000, payable now. The book would be written, printed and ready to sell to students in 2 years. It will be ready just before semester begins.

A cash flow of $100 would be made from each book sold, after all costs such as printing and delivery. There are 600 students per semester. Assume that every student buys a new text book. Remember that there are 2 semesters per year and students buy text books at the beginning of the semester.

Assume that text book publishers will sell the books at the same price forever and that the number of students is constant.

If the discount rate is 8% pa, given as an effective annual rate, what is the NPV of the project?

A student just won the lottery. She won $1 million in cash after tax. She is trying to calculate how much she can spend per month for the rest of her life. She assumes that she will live for another 60 years. She wants to withdraw equal amounts at the beginning of every month, starting right now.

All of the cash is currently sitting in a bank account which pays interest at a rate of 6% pa, given as an APR compounding per month. On her last withdrawal, she intends to have nothing left in her bank account. How much can she withdraw at the beginning of each month?

The following equation is the Dividend Discount Model, also known as the 'Gordon Growth Model' or the 'Perpetuity with growth' equation.

### p_0 = \frac{d_1}{r - g} ###

Which expression is **NOT** equal to the expected dividend yield?

A 2 year government bond yields 5% pa with a coupon rate of 6% pa, paid semi-annually.

Find the effective six month rate, effective annual rate and the effective daily rate. Assume that each month has 30 days and that there are 360 days in a year.

All answers are given in the same order:

##r_\text{eff semi-annual}##, ##r_\text{eff yrly}##, ##r_\text{eff daily}##.

The following equation is the Dividend Discount Model, also known as the 'Gordon Growth Model' or the 'Perpetuity with growth' equation.

###p_0=\frac{d_1}{r_\text{eff}-g_\text{eff}}###

Which expression is **NOT** equal to the expected capital return?

A share was bought for $10 (at t=0) and paid its annual dividend of $0.50 one year later (at t=1). Just after the dividend was paid, the share price was $11 (at t=1).

What was the total return, capital return and income return? Calculate your answers as effective annual rates. The choices are given in the same order:

##r_\text{total}##, ##r_\text{capital}##, ##r_\text{dividend}##.

A stock pays annual dividends. It just paid a dividend of $3. The growth rate in the dividend is 4% pa. You estimate that the stock's required return is 10% pa. Both the discount rate and growth rate are given as effective annual rates. Using the dividend discount model, what will be the share price?

A stock is expected to pay the following dividends:

Cash Flows of a Stock | ||||||

Time (yrs) | 0 | 1 | 2 | 3 | 4 | ... |

Dividend ($) | 8 | 8 | 8 | 20 | 8 | ... |

After year 4, the dividend will grow in perpetuity at 4% pa. The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates.

What will be the price of the stock in 5 years (t = 5), just after the dividend at that time has been paid?

Find Candys Corporation's Cash Flow From Assets (CFFA), also known as Free Cash Flow to the Firm (FCFF), over the year ending 30th June 2013.

Candys Corp | ||

Income Statement for | ||

year ending 30th June 2013 | ||

$m | ||

Sales | 200 | |

COGS | 50 | |

Operating expense | 10 | |

Depreciation | 20 | |

Interest expense | 10 | |

Income before tax | 110 | |

Tax at 30% | 33 | |

Net income | 77 | |

Candys Corp | ||

Balance Sheet | ||

as at 30th June | 2013 | 2012 |

$m | $m | |

Assets | ||

Current assets | 220 | 180 |

PPE | ||

Cost | 300 | 340 |

Accumul. depr. | 60 | 40 |

Carrying amount | 240 | 300 |

Total assets | 460 | 480 |

Liabilities | ||

Current liabilities | 175 | 190 |

Non-current liabilities | 135 | 130 |

Owners' equity | ||

Retained earnings | 50 | 60 |

Contributed equity | 100 | 100 |

Total L and OE | 460 | 480 |

Note: all figures are given in millions of dollars ($m).

Why is Capital Expenditure (CapEx) subtracted in the Cash Flow From Assets (CFFA) formula?

###CFFA=NI+Depr-CapEx - \Delta NWC+IntExp###

**Question 180** equivalent annual cash flow, inflation, real and nominal returns and cash flows

Details of two different types of light bulbs are given below:

- Low-energy light bulbs cost $3.50, have a life of nine years, and use about $1.60 of electricity a year, paid at the end of each year.
- Conventional light bulbs cost only $0.50, but last only about a year and use about $6.60 of energy a year, paid at the end of each year.

The real discount rate is 5%, given as an effective annual rate. Assume that all cash flows are real. The inflation rate is 3% given as an effective annual rate.

Find the Equivalent Annual Cost (EAC) of the low-energy and conventional light bulbs. The below choices are listed in that order.

A highly leveraged risky firm is trying to raise more debt. The types of debt being considered, in no particular order, are senior bonds, junior bonds, bank accepted bills, promissory notes and bank loans.

Which of these forms of debt is the safest from the perspective of the debt investors who are thinking of investing in the firm's new debt?

A stock is expected to pay the following dividends:

Cash Flows of a Stock | ||||||

Time (yrs) | 0 | 1 | 2 | 3 | 4 | ... |

Dividend ($) | 0 | 6 | 12 | 18 | 20 | ... |

After year 4, the dividend will grow in perpetuity at 5% pa. The required return of the stock is 10% pa. Both the growth rate and required return are given as effective annual rates.

If all of the dividends since time period zero were deposited into a bank account yielding **8%** pa as an effective annual rate, how much money will be in the bank account in 2.5 years (in other words, at t=2.5)?

There are a number of ways that assets can be depreciated. Generally the government's tax office stipulates a certain method.

But if it didn't, what would be the ideal way to depreciate an asset from the perspective of a businesses owner?

Interest expense (IntExp) is an important part of a company's income statement (or 'profit and loss' or 'statement of financial performance').

How does an **accountant** calculate the annual interest expense of a fixed-coupon bond that has a liquid secondary market? Select the most correct answer:

Annual interest expense is equal to:

**Question 207** income and capital returns, bond pricing, coupon rate, no explanation

For a bond that pays fixed semi-annual coupons, how is the annual coupon rate defined, and how is the bond's annual income yield from time 0 to 1 defined mathematically?

Let: ##P_0## be the bond price now,

##F_T## be the bond's face value,

##T## be the bond's maturity in years,

##r_\text{total}## be the bond's total yield,

##r_\text{income}## be the bond's income yield,

##r_\text{capital}## be the bond's capital yield, and

##C_t## be the bond's coupon at time t in years. So ##C_{0.5}## is the coupon in 6 months, ##C_1## is the coupon in 1 year, and so on.

**Question 210** real estate, inflation, real and nominal returns and cash flows, income and capital returns

Assume that the Gordon Growth Model (same as the dividend discount model or perpetuity with growth formula) is an appropriate method to value real estate.

The rule of thumb in the real estate industry is that properties should yield a **5**% pa rental return. Many investors also regard property to be as risky as the stock market, therefore property is thought to have a required **total** return of **9**% pa which is the average total return on the stock market including dividends.

Assume that all returns are effective annual rates and they are **nominal** (not reduced by inflation). Inflation is expected to be **2**% pa.

You're considering purchasing an investment property which has a rental yield of 5% pa and you expect it to have the same risk as the stock market. Select the most correct statement about this property.

**Question 213** income and capital returns, bond pricing, premium par and discount bonds

The coupon rate of a fixed annual-coupon bond is constant (always the same).

What can you say about the income return (##r_\text{income}##) of a fixed annual coupon bond? Remember that:

###r_\text{total} = r_\text{income} + r_\text{capital}###

###r_\text{total, 0 to 1} = \frac{c_1}{p_0} + \frac{p_1-p_0}{p_0}###

Assume that there is no change in the bond's total annual yield to maturity from when it is issued to when it matures.

Select the most correct statement.

From its date of issue until maturity, the **income return** of a fixed annual coupon:

A stock **just paid** its annual dividend of $9. The share price is $60. The required return of the stock is 10% pa as an effective annual rate.

What is the implied growth rate of the dividend per year?

A stock is expected to pay a dividend of $15 in one year (t=1), then $25 for 9 years after that (payments at t=2 ,3,...10), and on the 11th year (t=11) the dividend will be 2% less than at t=10, and will continue to shrink at the same rate every year after that forever. The required return of the stock is 10%. All rates are effective annual rates.

What is the price of the stock now?

**Question 218** NPV, IRR, profitability index, average accounting return

Which of the following statements is **NOT** correct?

Which one of the following bonds is trading at a premium?

A very low-risk stock just paid its semi-annual dividend of $0.14, as it has for the last 5 years. You conservatively estimate that from now on the dividend will fall at a rate of 1% every 6 months.

If the stock currently sells for $3 per share, what must be its required total return as an effective annual rate?

If risk free government bonds are trading at a yield of 4% pa, given as an effective annual rate, would you consider buying or selling the stock?

The stock's required total return is:

An investor bought two fixed-coupon bonds issued by the same company, a zero-coupon bond and a 7% pa semi-annual coupon bond. Both bonds have a face value of $1,000, mature in 10 years, and had a yield at the time of purchase of 8% pa.

A few years later, yields fell to 6% pa. Which of the following statements is correct? Note that a capital gain is an increase in price.

A stock has a beta of **0.5**. Its next dividend is expected to be $**3**, paid **one** year from now. Dividends are expected to be paid annually and grow by **2**% pa forever. Treasury bonds yield **5**% pa and the market portfolio's expected return is **10**% pa. All returns are effective annual rates.

What is the price of the stock now?

**Question 237** WACC, Miller and Modigliani, interest tax shield

Which of the following discount rates should be the **highest** for a levered company? Ignore the costs of financial distress.

**Question 239** income and capital returns, inflation, real and nominal returns and cash flows, interest only loan

A bank grants a borrower an **interest-only** residential mortgage loan with a very large 50% deposit and a **nominal** interest rate of **6%** that is not expected to change. Assume that inflation is expected to be a **constant 2%** pa over the life of the loan. Ignore credit risk.

From the bank's point of view, what is the long term expected **nominal capital** return of the loan asset?

Unrestricted negative gearing is allowed in Australia, New Zealand and Japan. Negative gearing laws allow income losses on investment properties to be deducted from a tax-payer's pre-tax personal income. Negatively geared investors benefit from this tax advantage. They also hope to benefit from capital gains which exceed the income losses.

For example, a property investor buys an apartment funded by an interest only mortgage loan. Interest expense is $2,000 per month. The rental payments received from the tenant living on the property are $1,500 per month. The investor can deduct this income loss of $500 per month from his pre-tax personal income. If his personal marginal tax rate is 46.5%, this saves $232.5 per month in personal income tax.

The advantage of negative gearing is an example of the benefits of:

**Question 241** Miller and Modigliani, leverage, payout policy, diversification, NPV

One of Miller and Modigliani's (M&M's) important insights is that a firm's managers should not try to achieve a particular level of leverage or interest tax shields under certain assumptions. So the firm's capital structure is irrelevant. This is because investors can make their own *personal* leverage and interest tax shields, so there's no need for managers to try to make *corporate* leverage and interest tax shields. This is true under the assumptions of equal tax rates, interest rates and debt availability for the person and the corporation, no transaction costs and symmetric information.

This principal of 'home-made' or 'do-it-yourself' leverage can also be applied to other topics. Read the following statements to decide which are true:

(I) Payout policy: a firm's managers should not try to achieve a particular pattern of equity payout.

(II) Agency costs: a firm's managers should not try to minimise agency costs.

(III) Diversification: a firm's managers should not try to diversify across industries.

(IV) Shareholder wealth: a firm's managers should not try to maximise shareholders' wealth.

Which of the above statement(s) are true?

**Question 245** foreign exchange rate, monetary policy, foreign exchange rate direct quote, no explanation

Investors expect Australia's central bank, the RBA, to leave the policy rate unchanged at their next meeting.

Then unexpectedly, the policy rate is reduced due to fears that Australia's GDP growth is slowing.

What do you expect to happen to Australia's exchange rate? Direct and indirect quotes are given from the perspective of an Australian.

The Australian dollar will:

Your neighbour asks you for a loan of $100 and offers to pay you back $120 in one year.

You don't actually have any money right now, but you can borrow and lend from the bank at a rate of 10% pa. Rates are given as effective annual rates.

Assume that your neighbour will definitely pay you back. Ignore interest tax shields and transaction costs.

The Net Present Value (NPV) of lending to your neighbour is $9.09. Describe what you would do to actually receive a $9.09 cash flow right now with zero net cash flows in the future.

You have $100,000 in the bank. The bank pays interest at 10% pa, given as an effective annual rate.

You wish to consume an equal amount now (t=0) and in one year (t=1) and have nothing left in the bank at the end (t=1).

How much can you consume at each time?

Your main expense is fuel for your car which costs $100 per month. You just refueled, so you won't need any more fuel for another month (first payment at t=1 month).

You have $2,500 in a bank account which pays interest at a rate of 6% pa, payable monthly. Interest rates are not expected to change.

Assuming that you have no income, in how many months time will you not have enough money to **fully** refuel your car?

In these tough economic times, central banks around the world have cut interest rates so low that they are practically zero. In some countries, government bond yields are also very close to zero.

A three year government bond with a face value of $100 and a coupon rate of 2% pa paid semi-annually was just issued at a yield of 0%. What is the price of the bond?

A 90-day $1 million Bank Accepted Bill (BAB) was bought for $990,000 and sold 30 days later for $996,000 (at t=30 days).

What was the total return, capital return and income return over the 30 days it was held?

Despite the fact that money market instruments such as bills are normally quoted with simple interest rates, please calculate your answers as compound interest rates, specifically, as effective 30-day rates, which is how the below answer choices are listed.

##r_\text{total}##, ##r_\text{capital}##, ## r_\text{income}##

A company's shares just paid their annual dividend of $2 each.

The stock price is now $40 (just after the dividend payment). The annual dividend is expected to grow by 3% every year forever. The assumptions of the dividend discount model are valid for this company.

What do you expect the effective annual **dividend yield** to be in 3 years (dividend yield from t=3 to t=4)?

On his 20th birthday, a man makes a resolution. He will deposit $**30** into a bank account at the **end** of every month starting from now, which is the start of the month. So the first payment will be in one month. He will write in his will that when he dies the money in the account should be given to charity.

The bank account pays interest at **6**% pa compounding **monthly**, which is not expected to change.

If the man lives for another **60** years, how much money will be in the bank account if he dies just after making his last (720th) payment?

You're trying to save enough money for a deposit to buy a house. You want to buy a house worth $400,000 and the bank requires a 20% deposit ($80,000) before it will give you a loan for the other $320,000 that you need.

You currently have no savings, but you just started working and can save $2,000 per month, with the first payment in one month from now. Bank interest rates on savings accounts are 4.8% pa with interest paid monthly and interest rates are not expected to change.

How long will it take to save the $80,000 deposit? Round your answer up to the nearest month.

A student won $**1**m in a lottery. Currently the money is in a bank account which pays interest at **6**% pa, given as an APR compounding per month.

She plans to spend $**20,000** at the **beginning** of every month from now on (so the first withdrawal will be at t=0). After each withdrawal, she will check how much money is left in the account. When there is less than $**500,000** left, she will donate that remaining amount to charity.

In how many months will she make her last withdrawal and donate the remainder to charity?

**Question 271** CAPM, option, risk, systematic risk, systematic and idiosyncratic risk

All things remaining equal, according to the capital asset pricing model, if the systematic variance of an asset increases, its required return will increase and its price will decrease.

If the idiosyncratic variance of an asset increases, its price will be unchanged.

What is the relationship between the price of a call or put **option** and the total, systematic and idiosyncratic variance of the **underlying asset** that the option is based on? Select the most correct answer.

Call and put option prices **in**crease when the:

All things remaining equal, the higher the correlation of returns between two stocks:

A **30** year Japanese government bond was just issued at **par** with a yield of **1.7**% pa. The fixed coupon payments are **semi-annual**. The bond has a face value of $**100**.

**Six months** later, just **after** the first coupon is paid, the yield of the bond increases to **2**% pa. What is the bond's **new** price?

Find the sample standard deviation of returns using the data in the table:

Stock Returns | |

Year | Return pa |

2008 | 0.3 |

2009 | 0.02 |

2010 | -0.2 |

2011 | 0.4 |

The returns above and standard deviations below are given in decimal form.

Let the standard deviation of returns for a share per month be ##\sigma_\text{monthly}##.

What is the formula for the standard deviation of the share's returns per year ##(\sigma_\text{yearly})##?

Assume that returns are independently and identically distributed (iid) so they have zero auto correlation, meaning that if the return was higher than average today, it does not indicate that the return tomorrow will be higher or lower than average.

**Question 308** risk, standard deviation, variance, no explanation

A stock's standard deviation of returns is expected to be:

- 0.09 per
**month**for the first 5 months; - 0.14 per
**month**for the next 7 months.

What is the expected standard deviation of the stock per **year** ##(\sigma_\text{annual})##?

Assume that returns are independently and identically distributed (iid) and therefore have zero auto-correlation.

**Question 320** foreign exchange rate, monetary policy, American and European terms

Investors expect the Reserve Bank of Australia (RBA) to decrease the overnight cash rate at their next meeting.

Then unexpectedly, the RBA announce that they will keep the policy rate unchanged.

What do you expect to happen to Australia's exchange rate in the short term? The Australian dollar is likely to:

**Question 322** foreign exchange rate, monetary policy, American and European terms

The market expects the Reserve Bank of Australia (RBA) to decrease the policy rate by 25 basis points at their next meeting.

Then unexpectedly, the RBA announce that they will decrease the policy rate by 50 basis points due to fears of a recession and deflation.

What do you expect to happen to Australia's exchange rate? The Australian dollar will:

The Chinese government attempts to fix its exchange rate against the US dollar and at the same time use monetary policy to fix its interest rate at a set level.

To be able to fix its exchange rate and interest rate in this way, what does the Chinese government actually do?

- Adopts capital controls to prevent financial arbitrage by private firms and individuals.
- Adopts the same interest rate (monetary policy) as the United States.
- Fixes inflation so that the domestic real interest rate is equal to the United States' real interest rate.

Which of the above statements is or are true?

In the 1997 Asian financial crisis many countries' exchange rates depreciated rapidly against the US dollar (USD). The Thai, Indonesian, Malaysian, Korean and Filipino currencies were severely affected. The below graph shows these Asian countries' currencies in USD per one unit of their currency, indexed to 100 in June 1997.

Of the statements below, which is **NOT** correct? The Asian countries':

Estimate Microsoft's (MSFT) share price using a price earnings (PE) multiples approach with the following assumptions and figures only:

- Apple, Google and Microsoft are comparable companies,
- Apple's (AAPL) share price is $526.24 and historical EPS is $40.32.
- Google's (GOOG) share price is $1,215.65 and historical EPS is $36.23.
- Micrsoft's (MSFT) historical earnings per share (EPS) is $2.71.

Source: Google Finance 28 Feb 2014.

Your poor friend asks to borrow some money from you. He would like $1,000 now (t=0) and every year for the next 5 years, so there will be 6 payments of $**1,000** from t=0 to t=5 inclusive. In return he will pay you $**10,000** in seven years from now (t=7).

What is the net present value (NPV) of lending to your friend?

Assume that your friend will definitely pay you back so the loan is risk-free, and that the yield on risk-free government debt is **10**% pa, given as an effective annual rate.

Which of the following investable assets are **NOT** suitable for valuation using PE multiples techniques?

Which one of the following will decrease net income (NI) but increase cash flow from assets (CFFA) in this year for a tax-paying firm, all else remaining constant?

Remember:

###NI = (Rev-COGS-FC-Depr-IntExp).(1-t_c )### ###CFFA=NI+Depr-CapEx - \Delta NWC+IntExp###Two years ago Fred bought a house for $**300,000**.

Now it's worth $**500,000**, based on recent similar sales in the area.

Fred's residential property has an expected total return of **8**% pa.

He rents his house out for $**2,000** per month, paid in advance. Every 12 months he plans to increase the rental payments.

The present value of 12 months of rental payments is $**23,173.86**.

The future value of 12 months of rental payments one year ahead is $**25,027.77**.

What is the expected annual growth rate of the rental payments? In other words, by what percentage increase will Fred have to raise the monthly rent by each year to sustain the expected annual total return of 8%?

Which firms tend to have **low** forward-looking price-earnings (PE) ratios?

Only consider firms with positive earnings, disregard firms with negative earnings and therefore negative PE ratios.

Your friend overheard that you need some cash and asks if you would like to borrow some money. She can lend you $**5,000** now (t=0), and in return she wants you to pay her back $1,000 in two years (t=2) and every year after that for the next 5 years, so there will be **6** payments of $**1,000** from t=**2** to t=**7** inclusive.

What is the net present value (NPV) of borrowing from your friend?

Assume that banks loan funds at interest rates of **10**% pa, given as an effective annual rate.

Which of the following investable assets are **NOT** suitable for valuation using PE multiples techniques?

Which firms tend to have **high** forward-looking price-earnings (PE) ratios?

Your friend is trying to find the net present value of a project. The project is expected to last for just one year with:

- a negative cash flow of
**-**$**1**million initially (t=0), and - a positive cash flow of $
**1.1**million in one year (t=1).

The project has a total required return of 10% pa due to its moderate level of undiversifiable risk.

Your friend is aware of the importance of opportunity costs and the time value of money, but he is unsure of how to find the NPV of the project.

He knows that the opportunity cost of investing the $1m in the project is the expected gain from investing the money in shares instead. Like the project, shares also have an expected return of 10% since they have moderate undiversifiable risk. This opportunity cost is $0.1m ##(=1m \times 10\%)## which occurs in one year (t=1).

He knows that the time value of money should be accounted for, and this can be done by finding the present value of the cash flows in one year.

Your friend has listed a few different ways to find the NPV which are written down below.

(I) ##-1m + \dfrac{1.1m}{(1+0.1)^1} ##

(II) ##-1m + \dfrac{1.1m}{(1+0.1)^1} - \dfrac{1m}{(1+0.1)^1} \times 0.1 ##

(III) ##-1m + \dfrac{1.1m}{(1+0.1)^1} - \dfrac{1.1m}{(1+0.1)^1} \times 0.1 ##

(IV) ##-1m + 1.1m - \dfrac{1.1m}{(1+0.1)^1} \times 0.1 ##

(V) ##-1m + 1.1m - 1.1m \times 0.1 ##

Which of the above calculations give the correct NPV? Select the most correct answer.

The hardest and most important aspect of business project valuation is the estimation of the:

Which of the following companies is most suitable for valuation using PE multiples techniques?

One and a half years ago Frank bought a house for $**600,000**. Now it's worth only $**500,000**, based on recent similar sales in the area.

The expected total return on Frank's residential property is **7**% pa.

He rents his house out for $**1,600** per month, paid in advance. Every 12 months he plans to increase the rental payments.

The present value of 12 months of rental payments is $**18,617.27**.

The future value of 12 months of rental payments one year in the future is $**19,920.48**.

What is the expected annual **rental** yield of the property? Ignore the costs of renting such as maintenance, real estate agent fees and so on.

**Question 405** DDM, income and capital returns, no explanation

The perpetuity with growth formula is:

###P_0= \dfrac{C_1}{r-g}###

Which of the following is **NOT** equal to the total required return (r)?

One year ago you bought $**100,000** of shares partly funded using a margin loan. The margin loan size was $**70,000** and the other $**30,000** was your own wealth or 'equity' in the share assets.

The interest rate on the margin loan was **7.84**% pa.

Over the year, the shares produced a dividend yield of **4**% pa and a capital gain of **5**% pa.

What was the **total** return on your **wealth**? Ignore taxes, assume that all cash flows (interest payments and dividends) were paid and received at the end of the year, and all rates above are effective annual rates.

Hint: Remember that wealth in this context is your equity (E) in the house asset (V = D+E) which is funded by the loan (D) and your deposit or equity (E).

**Question 407** income and capital returns, inflation, real and nominal returns and cash flows

A stock has a **real** expected total return of **7**% pa and a real expected capital return of **2**% pa.

Inflation is expected to be **2**% pa. All rates are given as effective annual rates.

What is the **nominal** expected total return, capital return and dividend yield? The answers below are given in the same order.

**Question 408** leverage, portfolio beta, portfolio risk, real estate, CAPM

You just bought a house worth $**1,000,000**. You financed it with an $**800,000** mortgage loan and a deposit of $**200,000**.

You estimate that:

- The house has a beta of
**1**; - The mortgage loan has a beta of
**0.2**.

What is the beta of the equity (the $200,000 deposit) that you have in your house?

Also, if the risk free rate is **5**% pa and the market portfolio's return is **10**% pa, what is the expected return on equity in your house? Ignore taxes, assume that all cash flows (interest payments and rent) were paid and received at the end of the year, and all rates are effective annual rates.

A firm plans to issue equity and use the cash raised to pay off its debt. No assets will be bought or sold. Ignore the costs of financial distress.

Which of the following statements is **NOT** correct, all things remaining equal?

**Question 413** CFFA, interest tax shield, depreciation tax shield

There are many ways to calculate a firm's free cash flow (FFCF), also called cash flow from assets (CFFA).

One method is to use the following formulas to transform net income (NI) into FFCF including interest and depreciation tax shields:

###FFCF=NI + Depr - CapEx -ΔNWC + IntExp###

###NI=(Rev - COGS - Depr - FC - IntExp).(1-t_c )###

Another popular method is to use EBITDA rather than net income. EBITDA is defined as:

###EBITDA=Rev - COGS - FC###

One of the below formulas correctly calculates FFCF from EBITDA, including interest and depreciation tax shields, giving an identical answer to that above. Which formula is correct?

A mature firm has constant expected future earnings and dividends. Both amounts are equal. So earnings and dividends are expected to be equal and unchanging.

Which of the following statements is **NOT** correct?

The accounting identity states that the book value of a company's assets (A) equals its liabilities (L) plus owners equity (OE), so A = L + OE.

The finance version states that the market value of a company's assets (V) equals the market value of its debt (D) plus equity (E), so V = D + E.

Therefore a business's assets can be seen as a portfolio of the debt and equity that fund the assets.

Let ##\sigma_\text{V total}^2## be the total variance of returns on assets, ##\sigma_\text{V syst}^2## be the systematic variance of returns on assets, and ##\sigma_\text{V idio}^2## be the idiosyncratic variance of returns on assets, and ##\rho_\text{D idio, E idio}## be the correlation between the idiosyncratic returns on debt and equity.

Which of the following equations is **NOT** correct?

The perpetuity with growth equation is:

###P_0=\dfrac{C_1}{r-g}###

Which of the following is **NOT** equal to the expected capital return as an effective annual rate?

In the 'Austin Powers' series of movies, the character Dr. Evil threatens to destroy the world unless the United Nations pays him a ransom (video 1, video 2). Dr. Evil makes the threat on two separate occasions:

- In 1969 he demands a ransom of $1 million (=10^6), and again;
- In 1997 he demands a ransom of $100 billion (=10^11).

If Dr. Evil's demands are equivalent in real terms, in other words $1 million will buy the same basket of goods in 1969 as $100 billion would in 1997, what was the implied inflation rate over the **28** years from 1969 to 1997?

The answer choices below are given as effective annual rates:

**Question 461** book and market values, ROE, ROA, market efficiency

One year ago a pharmaceutical firm floated by selling its 1 million shares for $100 each. Its book and market values of equity were both $100m. Its debt totalled $50m. The required return on the firm's assets was 15%, equity 20% and debt 5% pa.

In the year since then, the firm:

- Earned net income of $29m.
- Paid dividends totaling $10m.
- Discovered a valuable new drug that will lead to a massive 1,000 times increase in the firm's net income in 10 years after the research is commercialised. News of the discovery was publicly announced. The firm's systematic risk remains unchanged.

Which of the following statements is **NOT** correct? All statements are about current figures, not figures one year ago.

**Hint**: Book return on assets (ROA) and book return on equity (ROE) are ratios that accountants like to use to measure a business's *past* performance.

###\text{ROA}= \dfrac{\text{Net income}}{\text{Book value of assets}}###

###\text{ROE}= \dfrac{\text{Net income}}{\text{Book value of equity}}###

The required return on assets ##r_V## is a return that financiers like to use to estimate a business's *future* required performance which compensates them for the firm's assets' risks. If the business were to achieve realised historical returns equal to its required returns, then investment into the business's assets would have been a zero-NPV decision, which is neither good nor bad but fair.

###r_\text{V, 0 to 1}= \dfrac{\text{Cash flow from assets}_\text{1}}{\text{Market value of assets}_\text{0}} = \dfrac{CFFA_\text{1}}{V_\text{0}}###

Similarly for equity and debt.

A firm has **1** million shares which trade at a price of $**30** each. The firm is expected to announce earnings of $**3** million at the end of the year and pay an annual dividend of $**1.50** per share.

What is the firm's (forward looking) price/earnings (PE) ratio?

Total cash flows can be broken into income and capital cash flows. What is the name given to the **income** cash flow from owning shares?

A young lady is trying to decide if she should attend university or begin working straight away in her home town.

The young lady's grandma says that she should not go to university because she is less likely to marry the local village boy whom she likes because she will spend less time with him if she attends university.

What's the correct way to classify this item from a capital budgeting perspective when trying to decide whether to attend university?

The cost of not marrying the local village boy should be classified as:

**Question 488** income and capital returns, payout policy, payout ratio, DDM

Two companies BigDiv and ZeroDiv are exactly the same except for their dividend payouts.

BigDiv pays large dividends and ZeroDiv doesn't pay any dividends.

Currently the two firms have the same earnings, assets, number of shares, share price, expected total return and risk.

Assume a perfect world with no taxes, no transaction costs, no asymmetric information and that all assets including business projects are fairly priced and therefore zero-NPV.

All things remaining equal, which of the following statements is **NOT** correct?

A firm is considering a business project which costs $**11**m now and is expected to pay a constant $**1**m at the end of every year forever.

Assume that the initial $**11**m cost is funded using the firm's **existing cash** so no new equity or debt will be raised. The cost of capital is **10**% pa.

Which of the following statements about net present value (NPV), internal rate of return (IRR) and payback period is **NOT** correct?

**Question 490** expected and historical returns, accounting ratio

Which of the following is **NOT** a synonym of 'required return'?

A firm is considering a business project which costs $**10**m now and is expected to pay a single cash flow of $**12.1**m in two years.

Assume that the initial $**10**m cost is funded using the firm's **existing cash** so no new equity or debt will be raised. The cost of capital is **10**% pa.

Which of the following statements about net present value (NPV), internal rate of return (IRR) and payback period is **NOT** correct?

**Question 497** income and capital returns, DDM, ex dividend date

A stock will pay you a dividend of $**10** **tonight** if you buy it **today**. Thereafter the annual dividend is expected to grow by **5**% pa, so the next dividend after the $10 one tonight will be $10.50 in one year, then in two years it will be $11.025 and so on. The stock's required return is **10**% pa.

What is the stock price today and what do you expect the stock price to be tomorrow, approximately?

**Question 498** NPV, Annuity, perpetuity with growth, multi stage growth model

A business project is expected to cost $100 now (t=0), then pay $10 at the end of the third (t=3), fourth, fifth and sixth years, and then grow by 5% pa every year forever. So the cash flow will be $10.5 at the end of the seventh year (t=7), then $11.025 at the end of the eighth year (t=8) and so on perpetually. The total required return is 10℅ pa.

Which of the following formulas will **NOT** give the correct net present value of the project?

The below graph shows a project's net present value (NPV) against its annual discount rate.

Which of the following statements is **NOT** correct?

A share currently worth $**100** is expected to pay a constant dividend of $**4** for the next **5** years with the first dividend in one year (t=1) and the last in 5 years (t=5).

The total required return is **10**% pa.

What do you expected the share price to be in **5** years, just **after** the dividend at that time has been paid?

Which of the following equations is **NOT** equal to the total return of an asset?

Let ##p_0## be the current price, ##p_1## the expected price in one year and ##c_1## the expected income in one year.

A stock is **just about to pay** a dividend of $1 **tonight**. Future annual dividends are expected to grow by 2% pa. The next dividend of $1 will be paid tonight, and the year after that the dividend will be $1.02 (=1*(1+0.02)^1), and a year later 1.0404 (=1*(1+0.04)^2) and so on forever.

Its required total return is 10% pa. The total required return and growth rate of dividends are given as effective annual rates.

Calculate the current stock price.

The following cash flows are expected:

- Constant perpetual yearly payments of $70, with the first payment in 2.5 years from now (first payment at t=2.5).
- A single payment of $600 in 3 years and 9 months (t=3.75) from now.

What is the NPV of the cash flows if the discount rate is 10% given as an effective annual rate?

**Question 524** risk, expected and historical returns, bankruptcy or insolvency, capital structure, corporate financial decision theory, limited liability

Which of the following statements is **NOT** correct?

**Question 525** income and capital returns, real and nominal returns and cash flows, inflation

Which of the following statements about cash in the form of notes and coins is **NOT** correct? Assume that inflation is positive.

Notes and coins:

**Question 526** real and nominal returns and cash flows, inflation, no explanation

How can a **nominal** cash flow be precisely converted into a **real** cash flow?

**Question 531** bankruptcy or insolvency, capital structure, risk, limited liability

Who is most in danger of being **personally** bankrupt? Assume that all of their businesses' assets are highly liquid and can therefore be sold immediately.

You have $**100,000** in the bank. The bank pays interest at **10**% pa, given as an effective annual rate.

You wish to consume **twice** as much now (t=0) as in one year (t=1) and have nothing left in the bank at the end.

How much can you consume at time zero and one? The answer choices are given in the same order.

**Question 539** debt terminology, fully amortising loan, bond pricing

A 'fully amortising' loan can also be called a:

A firm wishes to raise $10 million now. They will issue 6% pa semi-annual coupon bonds that will mature in 3 years and have a face value of $100 each. Bond yields are 5% pa, given as an APR compounding every 6 months, and the yield curve is flat.

How many bonds should the firm issue?

**Question 545** income and capital returns, fully amortising loan, no explanation

Which of the following statements about the capital and income returns of a **25 year** **fully amortising** loan asset is correct?

Assume that the yield curve (which shows total returns over different maturities) is flat and is not expected to change.

Over the 25 years from issuance to maturity, a fully amortising loan's expected **annual** effective:

An investor bought a **10** year **2.5**% pa fixed coupon government bond priced at **par**. The face value is $**100**. Coupons are paid **semi-annually** and the next one is in 6 months.

**Six months later**, just **after** the coupon at that time was paid, yields suddenly and unexpectedly fell to **2**% pa. Note that all yields above are given as APR's compounding semi-annually.

What was the bond investors' historical total return over that first 6 month period, given as an effective semi-annual rate?

**Question 556** portfolio risk, portfolio return, standard deviation

An investor wants to make a portfolio of two stocks A and B with a target expected portfolio return of **12**% pa.

- Stock A has an expected return of
**10**% pa and a standard deviation of**20**% pa. - Stock B has an expected return of
**15**% pa and a standard deviation of**30**% pa.

The correlation coefficient between stock A and B's expected returns is **70**%.

What will be the annual standard deviation of the portfolio with this 12% pa target return?

**Question 559** variance, standard deviation, covariance, correlation

Which of the following statements about standard statistical mathematics notation is **NOT** correct?

What is the covariance of a variable X with itself?

The cov(X, X) or ##\sigma_{X,X}## equals:

What is the correlation of a variable X with itself?

The corr(X, X) or ##\rho_{X,X}## equals:

What is the covariance of a variable X with a constant C?

The cov(X, C) or ##\sigma_{X,C}## equals:

What is the correlation of a variable X with a constant C?

The corr(X, C) or ##\rho_{X,C}## equals:

**Question 566** capital structure, capital raising, rights issue, on market repurchase, dividend, stock split, bonus issue

A company's share price fell by 20% and its number of shares rose by 25%. Assume that there are no taxes, no signalling effects and no transaction costs.

Which one of the following corporate events may have happened?

An Indonesian lady wishes to convert 1 million Indonesian rupiah (IDR) to Australian dollars (AUD). Exchange rates are 13,125 IDR per USD and 0.79 USD per AUD. How many AUD is the IDR 1 million worth?

Over the next year, the management of an **unlevered** company plans to:

- Make $
**5**m in sales, $**1.9m**in net income and $**2**m in equity free cash flow (EFCF). - Pay dividends of $
**1**m. - Complete a $
**1.3**m share buy-back.

Assume that:

- All amounts are received and paid at the end of the year so you can ignore the time value of money.
- The firm has sufficient retained profits to legally pay the dividend and complete the buy back.
- The firm plans to run a very tight ship, with no excess cash above operating requirements currently or over the next year.

How much new equity financing will the company need? In other words, what is the value of new shares that will need to be issued?

Find the cash flow from assets (CFFA) of the following project.

Project Data | ||

Project life | 2 years | |

Initial investment in equipment | $6m | |

Depreciation of equipment per year for tax purposes | $1m | |

Unit sales per year | 4m | |

Sale price per unit | $8 | |

Variable cost per unit | $3 | |

Fixed costs per year, paid at the end of each year | $1.5m | |

Tax rate | 30% | |

Note 1: The equipment will have a book value of $4m at the end of the project for tax purposes. However, the equipment is expected to fetch $0.9 million when it is sold at t=2.

Note 2: Due to the project, the firm will have to purchase $0.8m of inventory initially, which it will sell at t=1. The firm will buy another $0.8m at t=1 and sell it all again at t=2 with zero inventory left. The project will have no effect on the firm's current liabilities.

Find the project's CFFA at time zero, one and two. Answers are given in millions of dollars ($m).

A managed fund charges fees based on the amount of money that you keep with them. The fee is **2**% of the **start**-of-year amount, but it is paid at the **end** of every year.

This fee is charged regardless of whether the fund makes gains or losses on your money.

The fund offers to invest your money in shares which have an expected return of **10**% pa before fees.

You are thinking of investing $**100,000** in the fund and keeping it there for **40** years when you plan to retire.

What is the Net Present Value (NPV) of investing your money in the fund? Note that the question is **not** asking how much money you will have in 40 years, it is asking: what is the **NPV** of investing in the fund? Assume that:

- The fund has no private information.
- Markets are weak and semi-strong form efficient.
- The fund's transaction costs are negligible.
- The cost and trouble of investing your money in shares by yourself, without the managed fund, is negligible.

**Question 416** real estate, market efficiency, income and capital returns, DDM, CAPM

A residential real estate investor believes that house prices will grow at a rate of **5**% pa and that rents will grow by **2**% pa forever.

All rates are given as nominal effective annual returns. Assume that:

- His forecast is true.
- Real estate is and always will be fairly priced and the capital asset pricing model (CAPM) is true.
- Ignore all costs such as taxes, agent fees, maintenance and so on.
- All rental income cash flow is paid out to the owner, so there is no re-investment and therefore no additions or improvements made to the property.
- The non-monetary benefits of owning real estate and renting remain constant.

Which one of the following statements is **NOT** correct? Over time:

Stocks in the United States usually pay **quarterly** dividends. For example, the retailer Wal-Mart Stores paid a $0.47 dividend every quarter over the 2013 calendar year and plans to pay a $0.48 dividend every quarter over the 2014 calendar year.

Using the dividend discount model and net present value techniques, calculate the stock price of Wal-Mart Stores assuming that:

- The time now is the beginning of January 2014. The next dividend of $
**0.48**will be received in**3**months (end of March 2014), with another 3 quarterly payments of $0.48 after this (end of June, September and December 2014). - The quarterly dividend will increase by
**2**% every year, but each quarterly dividend over the year will be equal. So each quarterly dividend paid in 2015 will be $0.4896 (##=0.48×(1+0.02)^1##), with the first at the end of March 2015 and the last at the end of December 2015. In 2016 each quarterly dividend will be $0.499392 (##=0.48×(1+0.02)^2##), with the first at the end of March 2016 and the last at the end of December 2016, and so on**forever**. - The total required return on equity is
**6**% pa. - The required return and growth rate are given as effective annual rates.
- All cash flows and rates are
**nominal**. Inflation is**3**% pa. - Dividend payment dates and ex-dividend dates are at the same time.
- Remember that there are 4 quarters in a year and 3 months in a quarter.

What is the current stock price?

Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $**105** million. A **cash** offer will be made that pays the fair price for the target's shares plus **75**% of the total synergy value. The cash will be paid out of the firm's cash holdings, no new debt or equity will be raised.

Firms Involved in the Takeover | ||

Acquirer | Target | |

Assets ($m) | 6,000 | 700 |

Debt ($m) | 4,800 | 400 |

Share price ($) | 40 | 20 |

Number of shares (m) | 30 | 15 |

Ignore transaction costs and fees. Assume that the firms' debt and equity are fairly priced, and that each firms' debts' risk, yield and values remain constant. The acquisition is planned to occur immediately, so ignore the time value of money.

Calculate the merged firm's share price and total number of shares after the takeover has been completed.

An investor owns a whole level of an old office building which is currently worth $1 million. There are three mutually exclusive projects that can be started by the investor. The office building level can be:

- Rented out to a tenant for one year at $0.1m paid immediately, and then sold for $0.99m in one year.
- Refurbished into more modern commercial office rooms at a cost of $1m now, and then sold for $2.4m when the refurbishment is finished in one year.
- Converted into residential apartments at a cost of $2m now, and then sold for $3.4m when the conversion is finished in one year.

All of the development projects have the same risk so the required return of each is **10**% pa. The table below shows the estimated cash flows and internal rates of returns (IRR's).

Mutually Exclusive Projects | |||

Project | Cash flow now ($) |
Cash flow in one year ($) |
IRR (% pa) |

Rent then sell as is | -900,000 | 990,000 | 10 |

Refurbishment into modern offices | -2,000,000 | 2,400,000 | 20 |

Conversion into residential apartments | -3,000,000 | 3,400,000 | 13.33 |

Which project should the investor accept?

A company has:

- 10 million common shares outstanding, each trading at a price of $90.
- 1 million preferred shares which have a face (or par) value of $100 and pay a constant dividend of 9% of par. They currently trade at a price of $120 each.
- Debentures that have a total face value of $60,000,000 and a yield to maturity of 6% per annum. They are publicly traded and their market price is equal to 90% of their face value.
- The risk-free rate is 5% and the market return is 10%.
- Market analysts estimate that the company's common stock has a beta of 1.2. The corporate tax rate is 30%.

What is the company's after-tax Weighted Average Cost of Capital (WACC)? Assume a classical tax system.

**Question 542** price gains and returns over time, IRR, NPV, income and capital returns, effective return

For an asset price to **double** every **10** years, what must be the expected future capital return, given as an effective annual rate?

**Question 547** PE ratio, Multiples valuation, DDM, income and capital returns, no explanation

A firm pays out all of its earnings as dividends. Because of this, the firm has no real growth in earnings, dividends or stock price since there is no re-investment back into the firm to buy new assets and make higher earnings. The dividend discount model is suitable to value this company.

The firm's revenues and costs are expected to increase by inflation in the foreseeable future. The firm has no debt. It operates in the services industry and has few physical assets so there is negligible depreciation expense and negligible net working capital required.

Which of the following statements about this firm's PE ratio is **NOT** correct? The PE ratio should:

Note: The inverse of x is 1/x.