**Question 295** inflation, real and nominal returns and cash flows, NPV

When valuing assets using discounted cash flow (net present value) methods, it is important to consider inflation. To properly deal with inflation:

(I) Discount nominal cash flows by nominal discount rates.

(II) Discount nominal cash flows by real discount rates.

(III) Discount real cash flows by nominal discount rates.

(IV) Discount real cash flows by real discount rates.

Which of the above statements is or are correct?

**Question 575** inflation, real and nominal returns and cash flows

You expect a **nominal** payment of $100 in 5 years. The **real** discount rate is 10% pa and the inflation rate is 3% pa. Which of the following statements is **NOT** correct?

You're considering making an investment in a particular company. They have preference shares, ordinary shares, senior debt and junior debt.

Which is the safest investment? Which will give the highest returns?

Which of the following statements about book and market equity is **NOT** correct?

The expression 'you have to spend money to make money' relates to which business decision?

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 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?

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?

An investor owns an empty block of land that has local government approval to be developed into a petrol station, car wash or car park. The council will only allow a single development so the projects are mutually exclusive.

All of the development projects have the same risk and the required return of each is 10% pa. Each project has an immediate cost and once construction is finished in one year the land and development will be sold. The table below shows the estimated costs payable now, expected sale prices in one year and the internal rates of returns (IRR's).

Mutually Exclusive Projects | |||

Project | Cost now ($) |
Sale price in one year ($) |
IRR (% pa) |

Petrol station | 9,000,000 | 11,000,000 | 22.22 |

Car wash | 800,000 | 1,100,000 | 37.50 |

Car park | 70,000 | 110,000 | 57.14 |

Which project should the investor accept?

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.

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 will be the price of the stock in three and a half years (t = 3.5)?

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 and last at t=12).
- 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?

A fixed coupon bond was bought for $90 and paid its annual coupon of $3 one year later (at t=1 year). Just after the coupon was paid, the bond price was $92 (at t=1 year). 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{income} ##.

You just signed up for a 30 year **interest-only** mortgage with monthly payments of $3,000 per month. The interest rate is 6% pa which is not expected to change.

How much did you borrow? After 15 years, just after the 180th payment at that time, how much will be owing on the mortgage? The interest rate is still 6% and is not expected to change. Remember that the mortgage is interest-only and that mortgage payments are paid in arrears (at the end of the month).

When using the dividend discount model to price a stock:

### p_{0} = \frac{d_1}{r - g} ###

The growth rate of dividends (g):

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 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?

**Question 604** inflation, real and nominal returns and cash flows

Apples and oranges currently cost $**1** each. Inflation is **5**% pa, and apples and oranges are equally affected by this inflation rate. Note that when payments are not specified as real, as in this question, they're conventionally assumed to be nominal.

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

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 578** inflation, real and nominal returns and cash flows

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

A newly floated farming company is financed with senior bonds, junior bonds, cumulative non-voting preferred stock and common stock. The new company has no retained profits and due to floods it was unable to record any revenues this year, leading to a loss. The firm is not bankrupt yet since it still has substantial contributed equity (same as paid-up capital).

On which securities must it pay interest or dividend payments in this terrible financial year?

**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.

The boss of WorkingForTheManCorp has a wicked (and unethical) idea. He plans to pay his poor workers one week late so that he can get more interest on his cash in the bank.

Every week he is supposed to pay his 1,000 employees $1,000 each. So $**1** million is paid to employees every week.

The boss was just about to pay his employees today, until he thought of this idea so he will actually pay them one week (**7** days) later for the work they did last week and every week in the future, forever.

Bank interest rates are **10**% pa, given as a real effective annual rate. So ##r_\text{eff annual, real} = 0.1## and the real effective weekly rate is therefore ##r_\text{eff weekly, real} = (1+0.1)^{1/52}-1 = 0.001834569##

All rates and cash flows are real, the inflation rate is **3**% pa and there are **52** weeks per year. The boss will always pay wages one week late. The business will operate forever with constant real wages and the same number of employees.

What is the net present value (**NPV**) of the boss's decision to pay later?

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?

Private equity firms are known to buy medium sized private companies operating in the same industry, merge them together into a larger company, and then sell it off in a public float (initial public offering, IPO).

If medium-sized private companies trade at PE ratios of **5** and larger listed companies trade at PE ratios of **15**, what return can be achieved from this strategy?

Assume that:

- The medium-sized companies can be bought, merged and sold in an IPO instantaneously.
- There are no costs of finding, valuing, merging and restructuring the medium sized companies. Also, there is no competition to buy the medium-sized companies from other private equity firms.
- The large merged firm's earnings are the sum of the medium firms' earnings.
- The only reason for the difference in medium and large firm's PE ratios is due to the illiquidity of the medium firms' shares.
- Return is defined as: ##r_{0→1} = (p_1-p_0+c_1)/p_0## , where time zero is just before the merger and time one is just after.

**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.

An industrial chicken farmer grows chickens for their meat. Chickens:

- Cost $
**0.50**each to buy as chicks. They are bought on the day they’re born, at t=**0**. - Grow at a rate of $
**0.70**worth of meat per chicken per week for the first 6 weeks (t=**0**to t=**6**). - Grow at a rate of $
**0.40**worth of meat per chicken per week for the next 4 weeks (t=**6**to t=**10**) since they’re older and grow more slowly. - Feed costs are $
**0.30**per chicken per week for their whole life. Chicken feed is bought and fed to the chickens once per week at the beginning of the week. So the first amount of feed bought for a chicken at t=**0**costs $0.30, and so on. - Can be slaughtered (killed for their meat) and sold at no cost at the
**end**of the week. The price received for the chicken is their total value of meat (note that the chicken grows fast then slow, see above).

The required return of the chicken farm is **0.5%** given as an effective **weekly** rate.

Ignore taxes and the fixed costs of the factory. Ignore the chicken’s welfare and other environmental and ethical concerns.

Find the equivalent **weekly** cash flow of slaughtering a chicken at **6** weeks and at **10** weeks so the farmer can figure out the best time to slaughter his chickens. The choices below are given in the same order, 6 and 10 weeks.

You just bought a nice dress which you plan to wear once per month on nights out. You bought it a moment ago for $600 (at t=0). In your experience, dresses used once per month last for 6 years.

Your younger sister is a student with no money and wants to borrow your dress once a month when she hits the town. With the increased use, your dress will only last for another 3 years rather than 6.

What is the present value of the cost of letting your sister use your current dress for the next 3 years?

Assume: that bank interest rates are 10% pa, given as an effective annual rate; you will buy a new dress when your current one wears out; your sister will only use the current dress, not the next one that you will buy; and the price of a new dress never changes.

You own a nice suit which you wear once per week on nights out. You bought it one year ago for $600. In your experience, suits used once per week last for 6 years. So you expect yours to last for another 5 years.

Your younger brother said that retro is back in style so he wants to wants to borrow your suit once a week when he goes out. With the increased use, your suit will only last for another 4 years rather than 5.

What is the present value of the cost of letting your brother use your current suit for the next 4 years?

Assume: that bank interest rates are 10% pa, given as an effective annual rate; you will buy a new suit when your current one wears out and your brother will not use the new one; your brother will only use your current suit so he will only use it for the next four years; and the price of a new suit never changes.

You own some nice shoes which you use once per week on date nights. You bought them **2** years ago for $**500**. In your experience, shoes used once per week last for **6** years. So you expect yours to last for another **4** years.

Your younger sister said that she wants to borrow your shoes once per week. With the increased use, your shoes will only last for another **2** years rather than 4.

What is the present value of the cost of letting your sister use your current shoes for the next 2 years?

Assume: that bank interest rates are **10**% pa, given as an effective annual rate; you will buy a new pair of shoes when your current pair wears out and your sister will not use the new ones; your sister will only use your current shoes so she will only use it for the next 2 years; and the price of new shoes never changes.

Carlos and Edwin are brothers and they both love Holden Commodore cars.

Carlos likes to buy the latest Holden Commodore car for **$40,000** every **4** years as soon as the new model is released. As soon as he buys the new car, he sells the old one on the second hand car market for **$20,000**. Carlos never has to bother with paying for repairs since his cars are brand new.

Edwin also likes Commodores, but prefers to buy 4-year old cars for **$20,000** and keep them for **11** years until the end of their life (new ones last for 15 years in total but the 4-year old ones only last for another 11 years). Then he sells the old car for **$2,000** and buys another 4-year old second hand car, and so on.

Every time Edwin buys a second hand 4 year old car he **immediately** has to spend **$1,000** on repairs, and then $1,000 every year after that for the next 10 years. So there are **11** payments in total from when the second hand car is bought at t=0 to the last payment at t=10. One year later (t=11) the old car is at the end of its total 15 year life and can be scrapped for $2,000.

Assuming that Carlos and Edwin maintain their love of Commodores and keep up their habits of buying new ones and second hand ones respectively, how much **larger** is Carlos' **equivalent annual cost** of car ownership compared with Edwin's?

The real discount rate is **10%** pa. All cash flows are real and are expected to remain constant. Inflation is forecast to be **3**% pa. All rates are effective annual. Ignore capital gains tax and tax savings from depreciation since cars are tax-exempt for individuals.

**Question 50** DDM, stock pricing, inflation, real and nominal returns and cash flows

Most listed Australian companies pay dividends twice per year, the 'interim' and 'final' dividends, which are roughly 6 months apart.

You are an equities analyst trying to value the company BHP. You decide to use the Dividend Discount Model (DDM) as a starting point, so you study BHP's dividend history and you find that BHP tends to pay the same interim and final dividend each year, and that both grow by the same rate.

You expect BHP will pay a $0.55 interim dividend in six months and a $0.55 final dividend in one year. You expect each to grow by 4% next year and forever, so the interim and final dividends next year will be $0.572 each, and so on in perpetuity.

Assume BHP's cost of equity is 8% pa. All rates are quoted as nominal effective rates. The dividends are nominal cash flows and the inflation rate is 2.5% pa.

What is the current price of a BHP share?

A home loan company advertises an interest rate of 6% pa, payable monthly. Which of the following statements about the interest rate is **NOT** correct? All rates are given to four decimal places.

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 want to buy an apartment worth $400,000. You have saved a deposit of $80,000. The bank has agreed to lend you the $320,000 as a **fully amortising** mortgage loan with a term of 30 years. The interest rate is 6% pa and is not expected to change. What will be your monthly payments?

You just agreed to a 30 year **fully amortising** mortgage loan with monthly payments of $2,500. The interest rate is 9% pa which is not expected to change.

How much did you borrow? After 10 years, how much will be owing on the mortgage? The interest rate is still 9% and is not expected to change. The below choices are given in the same order.

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?

You want to buy an apartment worth $300,000. You have saved a deposit of $60,000.

The bank has agreed to lend you $240,000 as an **interest only** mortgage loan with a term of 30 years. The interest rate is 6% pa and is not expected to change. What will be your monthly payments?

**Question 96** bond pricing, zero coupon bond, term structure of interest rates, forward interest rate

An Australian company just issued two bonds:

- A 1 year zero coupon bond at a yield of 8% pa, and
- A 2 year zero coupon bond at a yield of 10% pa.

What is the forward rate on the company's debt from years 1 to 2? Give your answer as an APR compounding every **6** months, which is how the above bond yields are quoted.

**Question 572** bond pricing, zero coupon bond, term structure of interest rates, expectations hypothesis, forward interest rate, yield curve

In the below term structure of interest rates equation, all rates are effective annual yields and the numbers in subscript represent the years that the yields are measured over:

###(1+r_{0-3})^3 = (1+r_{0-1})(1+r_{1-2})(1+r_{2-3}) ###

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

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.

**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?

"Buy low, sell high" is a phrase commonly heard in financial markets. It states that traders should try to buy assets at low prices and sell at high prices.

Traders in the fixed-coupon bond markets often quote promised bond yields rather than prices. Fixed-coupon bond traders should try to:

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.

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?

You really want to go on a back packing trip to Europe when you finish university. Currently you have $**1,500** in the bank. Bank interest rates are **8**% pa, given as an APR compounding per month. If the holiday will cost $**2,000**, how long will it take for your bank account to reach that amount?

For a price of $95, Sherylanne will sell you a share which is expected to pay its first dividend of $10 in 7 years (t=7), and will continue to pay the same $10 dividend every year after that forever.

The required return of the stock is 10% pa.

For a price of $95, Nicole will sell you a 10 year bond paying semi-annual coupons of 8% pa. The face value of the bond is $100. Other bonds with the same risk, maturity and coupon characteristics trade at a yield of 8% pa.

**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 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.

Let the 'income return' of a bond be the coupon at the end of the period divided by the market price now at the start of the period ##(C_1/P_0)##. The expected income return of a **premium** fixed coupon bond is:

**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 **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?

Bonds X and Y are issued by the same US company. Both bonds yield **6**% pa, and they have the same face value ($100), maturity, seniority, and payment frequency.

The only difference is that bond X pays coupons of **8**% pa and bond Y pays coupons of **12**% pa. Which of the following statements is true?

Below are some statements about loans and bonds. The first descriptive sentence is correct. But one of the second sentences about the loans' or bonds' prices is not correct. Which statement is **NOT** correct? Assume that interest rates are positive.

Note that coupons or interest payments are the periodic payments made throughout a bond or loan's life. The face or par value of a bond or loan is the amount paid at the end when the debt matures.

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?

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?

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?

**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.

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?

For certain shares, the forward-looking Price-Earnings Ratio (##P_0/EPS_1##) is equal to the inverse of the share's total expected return (##1/r_\text{total}##).

For what shares is this true?

Assume:

- The general accounting definition of 'payout ratio' which is dividends per share (DPS) divided by earnings per share (EPS).
- All cash flows, earnings and rates are real.

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?

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

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

All rates are effective annual rates and the cash flows (##d_1##) are received every year. Note that the r and g terms in the above DDM could also be labelled as below: ###r = r_{\text{total, 0}\rightarrow\text{1yr, eff 1yr}}### ###g = r_{\text{capital, 0}\rightarrow\text{1yr, eff 1yr}}### Which of the following statements is **NOT** correct?

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:

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?

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?

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?

Which of the following investable assets is the **LEAST** suitable for valuation using PE multiples techniques?

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?

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?

The below screenshot of Microsoft's (MSFT) details were taken from the Google Finance website on 28 Nov 2014. Some information has been deliberately blanked out.

What was MSFT's backwards-looking price-earnings ratio?

A firm has **2**m shares and a market capitalisation of equity of $**30**m. The firm just announced earnings of $**5**m and paid an annual dividend of $**0.75** per share.

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

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.

What is the current price of the stock?

On 22-Mar-2013 the Australian Government issued series TB139 treasury bonds with a combined face value $23.4m, listed on the ASX with ticker code GSBG25.

The bonds mature on **21-Apr-2025**, the fixed coupon rate is **3.25**% pa and coupons are paid **semi-annually** on the 21st of April and October of each year. Each bond's face value is $**1,000**.

At market close on Friday **11-Sep-2015** the bonds' yield was **2.736**% pa.

At market close on Monday **14-Sep-2015** the bonds' yield was **2.701**% pa. Both yields are given as annualised percentage rates (APR's) compounding every 6 months. For convenience, assume 183 days in 6 months and 366 days in a year.

What was the historical total return over those 3 calendar days between Friday 11-Sep-2015 and Monday 14-Sep-2015?

There are **183** calendar days from market close on the last coupon 21-Apr-2015 to the market close of the next coupon date on 21-Oct-2015.

Between the market close times from 21-Apr-2015 to 11-Sep-2015 there are **143** calendar days. From 21-Apr-2015 to 14-Sep-2015 there are **146** calendar days.

From 14-Sep-2015 there were **20** coupons remaining to be paid including the next one on 21-Oct-2015.

All of the below answers are given as effective 3 day rates.

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##.

A manufacturing company is considering a new project in the more risky services industry. The cash flows from assets (CFFA) are estimated for the new project, with interest expense excluded from the calculations. To get the levered value of the project, what should these unlevered cash flows be discounted by?

Assume that the manufacturing firm has a target debt-to-assets ratio that it sticks to.

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

Two risky stocks A and B comprise an equal-weighted portfolio. The correlation between the stocks' returns is 70%.

If the variance of stock A **increases** but the:

- Prices and expected returns of each stock stays the same,
- Variance of stock B's returns stays the same,
- Correlation of returns between the stocks stays the same.

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

What is the correlation of a variable X with itself?

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

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

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

Mr Blue, Miss Red and Mrs Green are people with different utility functions.

Note that a fair gamble is a bet that has an expected value of zero, such as paying $0.50 to win $1 in a coin flip with heads or nothing if it lands tails. Fairly priced insurance is when the expected present value of the insurance premiums is equal to the expected loss from the disaster that the insurance protects against, such as the cost of rebuilding a home after a catastrophic fire.

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

According to the theory of the Capital Asset Pricing Model (CAPM), total risk can be broken into two components, systematic risk and idiosyncratic risk. Which of the following events would be considered a systematic, undiversifiable event according to the theory of the CAPM?

A fairly priced stock has an expected return equal to the market's. Treasury bonds yield 5% pa and the market portfolio's expected return is 10% pa. What is the stock's beta?

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

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?

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?

**Question 119** market efficiency, fundamental analysis, joint hypothesis problem

Your friend claims that by reading 'The Economist' magazine's economic news articles, she can identify shares that will have positive abnormal expected returns over the next 2 years. Assuming that her claim is true, which statement(s) are correct?

(i) Weak form market efficiency is broken.

(ii) Semi-strong form market efficiency is broken.

(iii) Strong form market efficiency is broken.

(iv) The asset pricing model used to measure the abnormal returns (such as the CAPM) is either wrong (mis-specification error) or is measured using the wrong inputs (data errors) so the returns may not be abnormal but rather fair for the level of risk.

Select the most correct response:

Fundamentalists who analyse company financial reports and news announcements (but who don't have inside information) will make positive abnormal returns if:

The efficient markets hypothesis (EMH) and no-arbitrage pricing theory are most closely related to which of the following concepts?

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?

**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.

What is the net present value (NPV) of undertaking a full-time Australian undergraduate business degree as an Australian citizen? Only include the cash flows over the duration of the degree, ignore any benefits or costs of the degree after it's completed.

Assume the following:

- The degree takes
**3**years to complete and all students pass all subjects. - There are
**2**semesters per year and**4**subjects per semester. - University fees per subject per semester are
**$1,277**, paid at the**start**of each semester. Fees are expected to stay constant for the next 3 years. - There are
**52**weeks per year. - The first semester is just about to start (t=0). The first semester lasts for 19 weeks (t=
**0**to**19**). - The second semester starts immediately afterwards (t=19) and lasts for another 19 weeks (t=
**19**to**38**). - The summer holidays begin after the second semester ends and last for
**14**weeks (t=**38**to**52**). Then the first semester begins the next year, and so on. - Working full time at the grocery store instead of studying full-time pays
**$20**/hr and you can work**35**hours per week. Wages are paid at the**end**of each week. - Full-time students can work full-time during the summer holiday at the grocery store for the same rate of $20/hr for 35 hours per week. Wages are paid at the end of each week.
- The discount rate is
**9.8%**pa. All rates and cash flows are real. Inflation is expected to be**3%**pa. All rates are effective annual.

The NPV of costs from undertaking the university degree is:

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

Sidebar Corp | ||

Income Statement for | ||

year ending 30th June 2013 | ||

$m | ||

Sales | 405 | |

COGS | 100 | |

Depreciation | 34 | |

Rent expense | 22 | |

Interest expense | 39 | |

Taxable Income | 210 | |

Taxes at 30% | 63 | |

Net income | 147 | |

Sidebar Corp | ||

Balance Sheet | ||

as at 30th June | 2013 | 2012 |

$m | $m | |

Inventory | 70 | 50 |

Trade debtors | 11 | 16 |

Rent paid in advance | 4 | 3 |

PPE | 700 | 680 |

Total assets | 785 | 749 |

Trade creditors | 11 | 19 |

Bond liabilities | 400 | 390 |

Contributed equity | 220 | 220 |

Retained profits | 154 | 120 |

Total L and OE | 785 | 749 |

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

The cash flow from assets was:

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).

A firm has forecast its Cash Flow From Assets (CFFA) for this year and management is worried that it is too low. Which one of the following actions will lead to a higher CFFA for this year (t=0 to 1)? Only consider cash flows this year. Do not consider cash flows after one year, or the change in the NPV of the firm. Consider each action in isolation.

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

- Achieve firm free cash flow (FFCF or CFFA) of $1m.
- Pay dividends of $1.8m
- Complete a $1.3m share buy-back.
- Spend $0.8m on new buildings without buying or selling any other fixed assets. This capital expenditure is included in the CFFA figure quoted above.

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 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?

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?

Here are the Net Income (NI) and Cash Flow From Assets (CFFA) equations:

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

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

What is the formula for calculating annual interest expense (IntExp) which is used in the equations above?

Select one of the following answers. Note that D is the value of debt which is constant through time, and ##r_D## is the cost of debt.

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:

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?

A company announces that it will pay a dividend, as the market expected. The company's shares trade on the stock exchange which is open from 10am in the morning to 4pm in the afternoon each weekday. When would the share price be expected to fall by the amount of the dividend? Ignore taxes.

The share price is expected to fall during the:

**Question 568** rights issue, capital raising, capital structure

A company conducts a **1** for **5** rights issue at a subscription price of $**7** when the pre-announcement stock price was $**10**. What is the percentage change in the stock price and the number of shares outstanding? The answers are given in the same order. Ignore all taxes, transaction costs and signalling effects.

Which one of the following will have no effect on net income (NI) but decrease cash flow from assets (CFFA or FFCF) 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 - ΔNWC+IntExp###Find World Bar's Cash Flow From Assets (CFFA), also known as Free Cash Flow to the Firm (FCFF), over the year ending 30th June 2013.

World Bar | ||

Income Statement for | ||

year ending 30th June 2013 | ||

$m | ||

Sales | 300 | |

COGS | 150 | |

Operating expense | 50 | |

Depreciation | 40 | |

Interest expense | 10 | |

Taxable income | 50 | |

Tax at 30% | 15 | |

Net income | 35 | |

World Bar | ||

Balance Sheet | ||

as at 30th June | 2013 | 2012 |

$m | $m | |

Assets | ||

Current assets | 200 | 230 |

PPE | ||

Cost | 400 | 400 |

Accumul. depr. | 75 | 35 |

Carrying amount | 325 | 365 |

Total assets | 525 | 595 |

Liabilities | ||

Current liabilities | 150 | 205 |

Non-current liabilities | 235 | 250 |

Owners' equity | ||

Retained earnings | 100 | 100 |

Contributed equity | 40 | 40 |

Total L and OE | 525 | 595 |

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

A company increases the proportion of debt funding it uses to finance its assets by issuing bonds and using the cash to repurchase stock, leaving assets unchanged.

Ignoring the costs of financial distress, which of the following statements is **NOT** correct:

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.

A man is thinking about taking a day off from his casual painting job to relax.

He just woke up early in the morning and he's about to call his boss to say that he won't be coming in to work.

But he's thinking about the hours that he could work today (in the future) which are:

**Question 699** utility, risk aversion, utility function, gamble

Mr Blue, Miss Red and Mrs Green are people with different utility functions.

Each person has $50 of initial wealth. A coin toss game is offered to each person at a casino where the player can win or lose $50. Each player can flip a coin and if they flip heads, they receive $50. If they flip tails then they will lose $50. Which of the following statements is **NOT** correct?

**Question 701** utility, risk aversion, utility function, gamble

Mr Blue, Miss Red and Mrs Green are people with different utility functions.

Each person has $50 of initial wealth. A coin toss game is offered to each person at a casino where the player can win or lose $50. Each player can flip a coin and if they flip heads, they receive $50. If they flip tails then they will lose $50. Which of the following statements is **NOT** correct?

**Question 121** capital structure, leverage, financial distress, interest tax shield

Fill in the missing words in the following sentence:

All things remaining equal, as a firm's amount of debt funding falls, benefits of interest tax shields __________ and the costs of financial distress __________.

**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?

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

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

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?

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 formula for the present value of interest tax shields if the tax shields occur in perpetuity?

You may assume:

- the value of debt (D) is constant through time,
- The cost of debt and the yield on debt are equal and given by ##r_D##.
- the appropriate rate to discount interest tax shields is ##r_D##.
- ##\text{IntExp}=D.r_D##

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 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.

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 337** capital structure, interest tax shield, leverage, real and nominal returns and cash flows, multi stage growth model

A fast-growing firm is suitable for valuation using a multi-stage growth model.

It's **nominal** unlevered cash flow from assets (##CFFA_U##) at the end of this year (**t=1**) is expected to be $**1** million. After that it is expected to grow at a rate of:

**12**% pa for the next two years (from t=1 to 3),**5**% over the fourth year (from t=3 to 4), and**-1**% forever after that (from t=4 onwards). Note that this is a negative one percent growth rate.

Assume that:

- The nominal WACC
**after**tax is**9.5**% pa and is not expected to change. - The nominal WACC
**before**tax is**10**% pa and is not expected to change. - The firm has a target debt-to-
**equity**ratio that it plans to maintain. - The inflation rate is
**3**% pa. - All rates are given as
**nominal**effective annual rates.

What is the levered value of this fast growing firm's assets?

There are many ways to calculate a firm's free cash flow (FFCF), also called cash flow from assets (CFFA). Some include the annual interest tax shield in the cash flow and some do not.

Which of the below FFCF formulas include the interest tax shield in the cash flow?

###(1) \quad FFCF=NI + Depr - CapEx -ΔNWC + IntExp### ###(2) \quad FFCF=NI + Depr - CapEx -ΔNWC + IntExp.(1-t_c)### ###(3) \quad FFCF=EBIT.(1-t_c )+ Depr- CapEx -ΔNWC+IntExp.t_c### ###(4) \quad FFCF=EBIT.(1-t_c) + Depr- CapEx -ΔNWC### ###(5) \quad FFCF=EBITDA.(1-t_c )+Depr.t_c- CapEx -ΔNWC+IntExp.t_c### ###(6) \quad FFCF=EBITDA.(1-t_c )+Depr.t_c- CapEx -ΔNWC### ###(7) \quad FFCF=EBIT-Tax + Depr - CapEx -ΔNWC### ###(8) \quad FFCF=EBIT-Tax + Depr - CapEx -ΔNWC-IntExp.t_c### ###(9) \quad FFCF=EBITDA-Tax - CapEx -ΔNWC### ###(10) \quad FFCF=EBITDA-Tax - CapEx -ΔNWC-IntExp.t_c###The formulas for net income (NI also called earnings), EBIT and EBITDA are given below. Assume that depreciation and amortisation are both represented by 'Depr' and that 'FC' represents fixed costs such as rent.

###NI=(Rev - COGS - Depr - FC - IntExp).(1-t_c )### ###EBIT=Rev - COGS - FC-Depr### ###EBITDA=Rev - COGS - FC### ###Tax =(Rev - COGS - Depr - FC - IntExp).t_c= \dfrac{NI.t_c}{1-t_c}###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?

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

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

A company advertises an investment costing $**1,000** which they say is underpriced. They say that it has an expected total return of **15**% pa, but a required return of only **10**% pa. Of the **15**% pa total expected return, the dividend yield is expected to always be **7**% pa and rest is the capital yield.

Assuming that the company's statements are correct, what is the NPV of buying the investment if the **15**% total return lasts for the next 100 years (t=0 to 100), then reverts to **10**% after that time? Also, what is the NPV of the investment if the 15% return lasts forever?

In both cases, assume that the required return of 10% remains constant, the dividends can only be re-invested at **10**% pa and all returns are given as effective annual rates.

The answer choices below are given in the same order (15% for 100 years, and 15% forever):

A stock's total standard deviation of returns is **20**% pa. The market portfolio's total standard deviation of returns is **15**% pa. The beta of the stock is **0.8**.

What is the stock's **diversifiable** standard deviation?

**Question 668** buy and hold, market efficiency, idiom

A quote from the famous investor Warren Buffet: "Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell."

Buffet is referring to the buy-and-hold strategy which is to buy and never sell shares. Which of the following is a disadvantage of a buy-and-hold strategy? Assume that share markets are semi-strong form efficient. Which of the following is **NOT** an advantage of the strict buy-and-hold strategy? A disadvantage of the buy-and-hold strategy is that it reduces:

Which of the following is **NOT** a valid method for estimating the beta of a company's stock? Assume that markets are efficient, a long history of past data is available, the stock possesses idiosyncratic and market risk. The variances and standard deviations below denote total risks.

**Question 419** capital budgeting, NPV, interest tax shield, WACC, CFFA, CAPM, no explanation

Project Data | ||

Project life | 1 year | |

Initial investment in equipment | $6m | |

Depreciation of equipment per year | $6m | |

Expected sale price of equipment at end of project | 0 | |

Unit sales per year | 9m | |

Sale price per unit | $8 | |

Variable cost per unit | $6 | |

Fixed costs per year, paid at the end of each year | $1m | |

Interest expense in first year (at t=1) | $0.53m | |

Tax rate | 30% | |

Government treasury bond yield | 5% | |

Bank loan debt yield | 6% | |

Market portfolio return | 10% | |

Covariance of levered equity returns with market | 0.08 | |

Variance of market portfolio returns | 0.16 | |

Firm's and project's debt-to-assets ratio |
50% | |

**Notes**

- Due to the project, current assets will increase by $
**5**m now (t=0) and fall by $**5**m at the end (t=1). Current liabilities will not be affected.

**Assumptions**

- The debt-to-assets ratio will be kept constant throughout the life of the project. The amount of interest expense at the end of each period has been correctly calculated to maintain this constant debt-to-equity ratio.
- Millions are represented by 'm'.
- All cash flows occur at the start or end of the year as appropriate, not in the middle or throughout the year.
- All rates and cash flows are real. The inflation rate is 2% pa.
- All rates are given as effective annual rates.
- The 50% capital gains tax discount is not available since the project is undertaken by a firm, not an individual.

What is the net present value (NPV) of the project?

**Question 339** bond pricing, inflation, market efficiency, income and capital returns

Economic statistics released this morning were a surprise: they show a strong chance of consumer price inflation (CPI) reaching 5% pa over the next 2 years.

This is much higher than the previous forecast of 3% pa.

A vanilla fixed-coupon 2-year risk-free government bond was issued at **par** this morning, just **before** the economic news was released.

What is the expected change in bond price after the economic news this morning, and in the next 2 years? Assume that:

- Inflation remains at 5% over the next 2 years.
- Investors demand a constant real bond yield.
- The bond price falls by the (after-tax) value of the coupon the night before the ex-coupon date, as in real life.

A company advertises an investment costing $**1,000** which they say is underpriced. They say that it has an expected total return of **15**% pa, but a required return of only **10**% pa. Assume that there are no dividend payments so the entire 15% total return is all capital return.

Assuming that the company's statements are correct, what is the **NPV** of buying the investment if the 15% return lasts for the next **100** years (t=0 to 100), then reverts to 10% pa after that time? Also, what is the NPV of the investment if the 15% return lasts forever?

In both cases, assume that the required return of 10% remains constant. All returns are given as effective annual rates.

The answer choices below are given in the same order (15% for 100 years, and 15% forever):