Your friend just bought a house for $**1,000,000**. He financed it using a $**900,000** mortgage loan and a deposit of $**100,000**.

In the context of residential housing and mortgages, the 'equity' or 'net wealth' tied up in a house is the value of the house less the value of the mortgage loan. Assuming that your friend's only asset is his house, his net wealth is $100,000.

If house prices suddenly fall by **15%**, what would be your friend's percentage change in net wealth?

Assume that:

- No income (rent) was received from the house during the short time over which house prices fell.
- Your friend will not declare bankruptcy, he will always pay off his debts.

Which of the following statements about the weighted average cost of capital (WACC) is **NOT** correct?

A company can invest funds in a five year project at LIBOR plus **50** basis points pa. The five-year swap rate is **4**% pa. What fixed rate of interest can the company earn over the next five years by using the swap?

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 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:

**Question 667** forward foreign exchange rate, foreign exchange rate, cross currency interest rate parity, no explanation

The Australian cash rate is expected to be **2**% pa over the next one year, while the US cash rate is expected to be **0**% pa, both given as nominal effective annual rates. The current exchange rate is **0.73** USD per AUD.

What is the implied 1 year USD per AUD forward foreign exchange rate?

A company conducts a **2** for **3** rights issue at a subscription price of $**8** when the pre-announcement stock price was $**9**. Assume that all investors use their rights to buy those extra shares.

What is the percentage increase in the stock price and the number of shares outstanding? The answers are given in the same order.

A company conducts a **10** for **3** stock split. What is the percentage increase in the stock price and the number of shares outstanding? The answers are given in the same order.

**Question 664** real and nominal returns and cash flows, inflation, no explanation

What is the present value of **real** payments of $100 every year forever, with the first payment in one year? The **nominal** discount rate is 7% pa and the inflation rate is 4% pa.

A firm has a debt-to-assets ratio of **20**%. What is its debt-to-**equity** ratio?

**Question 662** APR, effective rate, effective rate conversion, no explanation

Which of the following interest rate labels does **NOT** make sense?

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?

How much more can you borrow using an **interest-only** loan compared to a **25**-year **fully amortising** loan if interest rates are **6**% pa compounding per month and are not expected to change? If it makes it easier, assume that you can afford to pay $2,000 per month on either loan. Express your answer as a proportional increase using the following formula:

**Question 659** APR, effective rate, effective rate conversion, no explanation

A home loan company advertises an interest rate of 9% pa, payable monthly. Which of the following statements about the interest rate is **NOT** correct? All rates are given with an accuracy of 4 decimal places.

**Question 658** CFFA, income statement, balance sheet, no explanation

To value a business's assets, the free cash flow of the firm (FCFF, also called CFFA) needs to be calculated. This requires figures from the firm's income statement and balance sheet. For what figures is the income statement needed? Note that the income statement is sometimes also called the profit and loss, P&L, or statement of financial performance.

**Question 657** systematic and idiosyncratic risk, CAPM, no explanation

A stock's **required** total return will **decrease** when its:

The 'time value of money' is most closely related to which of the following concepts?

Which of the following statements about futures and forward contracts is **NOT** correct?

An equity index is currently at **4,800** points. The **1.5** year futures price is **5,100** points and the total required return is **6**% pa with continuous compounding. Each index point is worth $25.

What is the implied dividend yield as a continuously compounded rate per annum?

An equity index is currently at **5,200** points. The **6** month futures price is **5,300** points and the total required return is **6**% pa with continuous compounding. Each index point is worth $25.

What is the implied dividend yield as a continuously compounded rate per annum?

In February a company sold one December 40,000 pound (about 18 metric tons) lean hog futures contract. It closed out its position in May.

The spot price was $**0.68** per pound in February. The December futures price was $**0.70** per pound when the trader entered into the contract in February, $**0.60** when he closed out his position in May, and $**0.55** when the contract matured in December.

What was the total profit?

A trader **sells** a one year futures contract on crude oil. The contract is for the delivery of 1,000 barrels. The current futures price is $38.94 per barrel. The initial margin is $3,410 per contract, and the maintenance margin is $3,100 per contract.

What is the smallest price change that would lead to a margin call for the seller?

A trader **buys** a one year futures contract on crude oil. The contract is for the delivery of 1,000 barrels. The current futures price is $38.94 per barrel. The initial margin is $3,410 per contract, and the maintenance margin is $3,100 per contract.

What is the smallest price change that would lead to a margin call for the buyer?

Alice, Bob, Chris and Delta are traders in the futures market. The following trades occur over a single day in a newly-opened equity index future that matures in one year which the exchange just made available.

1. Alice buys a future from Bob.

2. Chris buys a future from Delta.

3. Delta buys a future from Bob.

These were the only trades made in this equity index future. What was the trading volume and what is the open interest?

Alice, Bob, Chris and Delta are traders in the futures market. The following trades occur over a single day in a newly-opened equity index future that matures in one year which the exchange just made available.

1. Alice buys a future from Bob.

2. Chris buys a future from Delta.

3. Delta buys a future from Alice.

These were the only trades made in this equity index future. What was the trading volume and what is the open interest?

A trader **buys** one crude oil European style **call** option contract on the CME expiring in one year with an exercise price of $44 per barrel for a price of $6.64. The crude oil spot price is $40.33. If the trader doesn’t close out her contract before maturity, then at maturity she will have the:

A trader **sells** one crude oil **futures** contract on the CME expiring in one year with a locked-in futures price of $38.94 per barrel. The crude oil spot price is $40.33. If the trader doesn’t close out her contract before expiry then in one year she will have the:

A trader **buys** one crude oil **futures** contract on the CME expiring in one year with a locked-in futures price of $38.94 per barrel. If the trader doesn’t close out her contract before expiry then in one year she will have the:

Which of the below formulas gives the payoff at maturity ##(f_T)## from being **short** a future? Let the underlying asset price at maturity be ##S_T## and the locked-in futures price be ##K_T##.

Which of the below formulas gives the payoff at maturity ##(f_T)## from being **long** a future? Let the underlying asset price at maturity be ##S_T## and the locked-in futures price be ##K_T##.

Which one of the below option and futures contracts gives the possibility of potentially unlimited gains?

**Question 639** option, option payoff at maturity, no explanation

Which of the below formulas gives the payoff ##(f)## at maturity ##(T)## from being **short** a **put** option? Let the underlying asset price at maturity be ##S_T## and the exercise price be ##X_T##.

**Question 638** option, option payoff at maturity, no explanation

Which of the below formulas gives the payoff ##(f)## at maturity ##(T)## from being **long** a **put** option? Let the underlying asset price at maturity be ##S_T## and the exercise price be ##X_T##.

**Question 637** option, option payoff at maturity, no explanation

Which of the below formulas gives the payoff ##(f)## at maturity ##(T)## from being **short** a **call** option? Let the underlying asset price at maturity be ##S_T## and the exercise price be ##X_T##.

**Question 636** option, option payoff at maturity, no explanation

Which of the below formulas gives the payoff ##(f)## at maturity ##(T)## from being **long** a **call** option? Let the underlying asset price at maturity be ##S_T## and the exercise price be ##X_T##.

A $**100** stock has a continuously compounded expected **total** return of **10**% pa. Its **dividend** yield is **2**% pa with continuous compounding. What do you expect its price to be in **2.5** years?

A $**100** stock has a continuously compounded expected **total** return of **10**% pa. Its **dividend** yield is **2**% pa with continuous compounding. What do you expect its price to be in **one** year?

In 2014 the median starting salaries of male and female Australian bachelor degree accounting graduates aged less than 25 years in their first full-time industry job was $50,000 before tax, according to Graduate Careers Australia. See page 9 of this report. Personal income tax rates published by the Australian Tax Office are reproduced for the 2014-2015 financial year in the table below.

Taxable income | Tax on this income |
---|---|

0 – $18,200 | Nil |

$18,201 – $37,000 | 19c for each $1 over $18,200 |

$37,001 – $80,000 | $3,572 plus 32.5c for each $1 over $37,000 |

$80,001 – $180,000 | $17,547 plus 37c for each $1 over $80,000 |

$180,001 and over | $54,547 plus 45c for each $1 over $180,000 |

The above rates do not include the Medicare levy of 2%. Exclude the Medicare levy from your calculations

How much personal income tax would you have to pay per year if you earned $50,000 per annum before-tax?

Below is a graph of the USD against the JPY and EUR from 1980 to 2015, compiled by the RBA. Select the correct statement about what occurred between 1980 and 2015. Note that in 1980 the euro was around 1.3 USD per EUR and the Yen was around 250 JPY per USD.

The Australian dollar's value was:

Did the Australian dollar or against the US dollar between these dates?

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):

Which of the following statements about yield curves is **NOT** correct?

Assets A, B, M and ##r_f## are shown on the graphs above. Asset M is the market portfolio and ##r_f## is the risk free yield on government bonds. Assume that investors can borrow and lend at the risk free rate. Which of the below statements is **NOT** correct?

Assets A, B, M and ##r_f## are shown on the graphs above. Asset M is the market portfolio and ##r_f## is the risk free yield on government bonds. Which of the below statements is **NOT** correct?

**Question 626** cross currency interest rate parity, foreign exchange rate, forward foreign exchange rate

The Australian cash rate is expected to be **2**% pa over the next one year, while the Japanese cash rate is expected to be **0**% pa, both given as nominal effective annual rates. The current exchange rate is **100** JPY per AUD.

What is the implied **1** year forward foreign exchange rate?

**Question 625** dividend re-investment plan, capital raising

Which of the following statements about dividend re-investment plans (DRP's) is **NOT** correct?

**Question 624** franking credit, personal tax on dividends, imputation tax system, no explanation

Which of the following statements about Australian franking credits is **NOT** correct? Franking credits:

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

An economy has only two investable assets: stocks and cash.

Stocks had a historical nominal average total return of negative two percent per annum (-2% pa) over the last 20 years. Stocks are liquid and actively traded. Stock returns are variable, they have risk.

Cash is riskless and has a nominal constant return of zero percent per annum (0% pa), which it had in the past and will have in the future. Cash can be kept safely at zero cost. Cash can be converted into shares and vice versa at zero cost.

The nominal total return of the shares over the **next** year is **expected** to be:

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:

To value a business's assets, the free cash flow of the firm (FCFF, also called CFFA) needs to be calculated. This requires figures from the firm's income statement and balance sheet. For what figures is the balance sheet needed? Note that the balance sheet is sometimes also called the statement of financial position.

A stock's required total return will **increase** when its:

"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:

**Question 606** foreign exchange rate, American and European terms

Which of the following FX quotes (current in October 2015) is given in American terms?

**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?

A Chinese man wishes to convert **AUD 1 million** into Chinese Renminbi (RMB, also called the Yuan (CNY)). The exchange rate is **6.35 RMB per USD**, and **0.72 USD per AUD**. How much is the AUD 1 million worth in RMB?

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.

**Question 598** future, tailing the hedge, cross hedging

The standard deviation of monthly changes in the spot price of lamb is $**0.015** per pound. The standard deviation of monthly changes in the futures price of live cattle is $**0.012** per pound. The correlation between the spot price of lamb and the futures price of cattle is **0.4**.

It is now January. A lamb producer is committed to selling **1,000,000** pounds of lamb in May. The spot price of live cattle is $**0.30** per pound and the June futures price is $**0.32** per pound. The spot price of lamb is $**0.60** per pound.

The producer wants to use the June live cattle futures contracts to hedge his risk. Each futures contract is for the delivery of **50,000** pounds of cattle.

How many live cattle futures should the lamb farmer sell to hedge his risk? Round your answer to the nearest whole number of contracts.

A stock is expected to pay a dividend of $**5** per share in **1** month and $**5** again in **7** months.

The stock price is $**100**, and the risk-free rate of interest is **10**% per annum with continuous compounding. The yield curve is flat. Assume that investors are risk-neutral.

An investor has just taken a **short** position in a **one** year forward contract on the stock.

Find the forward price ##(F_1)## and value of the contract ##(V_0)## initially. Also find the value of the short futures contract in 6 months ##(V_\text{0.5, SF})## if the stock price fell to $**90**.

An equity index is currently at **5,000** points. The **2** year futures price is **5,400** points and the total required return is **8**% pa with continuous compounding. Each index point is worth $**25**.

What is the implied continuous dividend yield as a continuously compounded rate per annum?

A **2**-year futures contract on a stock paying a continuous dividend yield of **3**% pa was bought when the underlying stock price was $**10** and the risk free rate was **10**% per annum with **continuous compounding**. Assume that investors are risk-neutral, so the stock's total required return is the risk free rate.

Find the forward price ##(F_2)## and value of the contract ##(V_0)## initially. Also find the value of the contract in 6 months ##(V_{0.5})## if the stock price rose to $**12**.

The current gold price is $**700**, gold storage costs are **2**% pa and the risk free rate is **10**% pa, both with **continuous compounding**.

What should be the **3** year gold futures price?

The price of gold is currently $**700** per ounce. The forward price for delivery in 1 year is $**800**. An arbitrageur can borrow money at **10**% per annum given as an effective discrete annual rate. Assume that gold is fairly priced and the cost of storing gold is zero.

What is the best way to conduct an arbitrage in this situation? The best arbitrage strategy requires zero capital, has zero risk and makes money straight away. An arbitrageur should **sell 1 forward** on gold and:

A trader **buys** one December futures contract on orange juice. Each contract is for the delivery of **10,000** pounds. The current futures price is $**1.20** per pound. The initial margin is $**5,000** per contract, and the maintenance margin is $**4,000** per contract.

What is the smallest price change would that would lead to a margin call for the buyer?

After doing extensive fundamental analysis of a company, you believe that their shares are overpriced and will soon fall significantly. The market believes that there will be no such fall.

Which of the following strategies is **NOT** a good idea, assuming that your prediction is true?

Which of the following statements about futures contracts on shares is **NOT** correct, assuming that markets are efficient?

When an equity future is first negotiated (at t=0):

In general, stock prices tend to rise. What does this mean for futures on equity?

If trader A has sold the right that allows counterparty B to buy the underlying asset from him at maturity if counterparty B wants then trader A is:

Which of the following statements about option contracts is **NOT** correct? For every:

A man just **sold** a **call** option to his counterparty, a lady. The man has just now:

**Question 584** option, option payoff at maturity, option profit

Which of the following statements about European call options on non-dividend paying stocks is **NOT** correct?

A semi-annual coupon bond has a yield of 3% pa. Which of the following statements about the yield is **NOT** correct? All rates are given to four decimal places.

A credit card company advertises an interest rate of 18% pa, payable monthly. Which of the following statements about the interest rate is **NOT** correct? All rates are given to four decimal places.

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.

**Question 580** price gains and returns over time, time calculation, effective rate

How many years will it take for an asset's price to **quadruple** (be four times as big, say from $1 to $4) if the price grows by **15**% pa?

**Question 579** price gains and returns over time, time calculation, effective rate

How many years will it take for an asset's price to **double** if the price grows by **10**% pa?

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

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

**Question 577** inflation, real and nominal returns and cash flows

What is the present value of a **real** payment of $500 in 2 years? The **nominal** discount rate is 7% pa and the inflation rate is 4% pa.

**Question 576** inflation, real and nominal returns and cash flows

What is the present value of a **nominal** payment of $1,000 in 4 years? The **nominal** discount rate is 8% pa and the inflation rate is 2% pa.

**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?

**Question 574** inflation, real and nominal returns and cash flows, NPV

What is the present value of a **nominal** payment of $100 in 5 years? The **real** discount rate is 10% pa and the inflation rate is 3% pa.

**Question 573** bond pricing, zero coupon bond, term structure of interest rates, expectations hypothesis, liquidity premium theory, 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?

**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?

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?

An American wishes to convert **USD 1 million** to Australian dollars (AUD). The exchange rate is **0.8 USD per AUD**. How much is the USD 1 million worth in AUD?

The average weekly earnings of an Australian adult worker before tax was $1,542.40 per week in November 2014 according to the Australian Bureau of Statistics. Therefore average annual earnings before tax were $**80,204.80** assuming 52 weeks per year. Personal income tax rates published by the Australian Tax Office are reproduced for the 2014-2015 financial year in the table below:

Taxable income | Tax on this income |
---|---|

0 – $18,200 | Nil |

$18,201 – $37,000 | 19c for each $1 over $18,200 |

$37,001 – $80,000 | $3,572 plus 32.5c for each $1 over $37,000 |

$80,001 – $180,000 | $17,547 plus 37c for each $1 over $80,000 |

$180,001 and over | $54,547 plus 45c for each $1 over $180,000 |

The above rates do not include the Medicare levy of 2%. Exclude the Medicare levy from your calculations

How much personal income tax would you have to pay per year if you earned $80,204.80 per annum before-tax?

**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.

A company conducts a **4** for **3** stock split. What is the percentage change in the stock price and the number of shares outstanding? The answers are given in the same order.

**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?

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

The corr(X, C) or ##\rho_{X,C}## 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 itself?

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

What is the covariance of a variable X with itself?

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

The covariance and correlation of two stocks X and Y's annual returns are calculated over a number of years. The units of the returns are in percent per annum ##(\% pa)##.

What are the units of the covariance ##(\sigma_{X,Y})## and correlation ##(\rho_{X,Y})## of returns respectively?

**Hint**: Visit Wikipedia to understand the difference between percentage points ##(\text{pp})## and percent ##(\%)##.

The standard deviation and variance of a stock's annual returns are calculated over a number of years. The units of the returns are percent per annum ##(\% pa)##.

What are the units of the standard deviation ##(\sigma)## and variance ##(\sigma^2)## of returns respectively?

**Hint**: Visit Wikipedia to understand the difference between percentage points ##(\text{pp})## and percent ##(\%)##.

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

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

**Question 558** portfolio weights, portfolio return, short selling

An investor wants to make a portfolio of two stocks A and B with a target expected portfolio return of **16**% pa.

- Stock A has an expected return of
**8**% pa. - Stock B has an expected return of
**12**% pa.

What portfolio weights should the investor have in stocks A and B respectively?

An investor wants to make a portfolio of two stocks A and B with a target expected portfolio return of **6**% pa.

- Stock A has an expected return of
**5**% pa. - Stock B has an expected return of
**10**% pa.

What portfolio weights should the investor have in stocks A and B respectively?

**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?

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

Project Data | |

Project life | 2 years |

Initial investment in equipment | $8m |

Depreciation of equipment per year for tax purposes | $3m |

Unit sales per year | 10m |

Sale price per unit | $9 |

Variable cost per unit | $4 |

Fixed costs per year, paid at the end of each year | $2m |

Tax rate | 30% |

Note 1: Due to the project, the firm will have to purchase $40m of inventory initially (at t=0). Half of this inventory will be sold at t=1 and the other half at t=2.

Note 2: The equipment will have a book value of $2m at the end of the project for tax purposes. However, the equipment is expected to fetch $1m when it is sold. Assume that the full capital loss is tax-deductible and taxed at the full corporate tax rate.

Note 3: The project will be fully funded by equity which investors will expect to pay dividends totaling $10m at the end of each year.

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

**Question 554** inflation, real and nominal returns and cash flows

On his 20th birthday, a man makes a resolution. He will put $**30** cash under his bed at the **end** of every month starting from today. His birthday today is the first day of the month. So the first addition to his cash stash will be in one month. He will write in his will that when he dies the cash under the bed should be given to charity.

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

Also, what will be the **real** value of that cash in today's prices if inflation is expected to **2.5%** pa? Assume that the inflation rate is an effective annual rate and is not expected to change.

The answers are given in the same order, the amount of money under his bed in 60 years, and the real value of that money in today's prices.

An investor bought a **20** year **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 rose to **5.5**% 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?

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?

You just entered into a fully amortising home loan with a principal of $**600,000**, a variable interest rate of **4.25**% pa and a term of **25** years.

Immediately after settling the loan, the variable interest rate suddenly falls to **4**% pa! You can't believe your luck. Despite this, you plan to continue paying the same home loan payments as you did before. How long will it now take to pay off your home loan?

Assume that the lower interest rate was granted immediately and that rates were and are now again expected to remain constant. Round your answer up to the nearest whole month.

**Question 550** fully amortising loan, interest only loan, APR, no explanation

Many Australian home loans that are interest-only actually require payments to be made on a fully amortising basis after a number of years.

You decide to borrow $**600,000** from the bank at an interest rate of **4.25**% pa for 25 years. The payments will be **interest-only** for the first **10** years (t=0 to 10 years), then they will have to be paid on a **fully amortising** basis for the last **15** years (t=10 to 25 years).

Assuming that interest rates will remain constant, what will be your monthly payments over the first 10 years from now, and then the next 15 years after that? The answer options are given in the same order.

An Apple iPhone 6 smart phone can be bought now for $**999**. An Android Samsung Galaxy 5 smart phone can be bought now for $**599**.

If the Samsung phone lasts for **four** years, approximately how long must the Apple phone last for to have the same equivalent annual cost?

Assume that both phones have equivalent features besides their lifetimes, that both are worthless once they've outlasted their life, the discount rate is **10**% pa given as an effective annual rate, and there are no extra costs or benefits from either phone.

**Question 548** equivalent annual cash flow, time calculation, no explanation

An Apple iPhone 6 smart phone can be bought now for $**999**. An Android Kogan Agora 4G+ smart phone can be bought now for $**240**.

If the Kogan phone lasts for **one** year, approximately how long must the Apple phone last for to have the same equivalent annual cost?

Assume that both phones have equivalent features besides their lifetimes, that both are worthless once they've outlasted their life, the discount rate is **10**% pa given as an effective annual rate, and there are no extra costs or benefits from either phone.

**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.

**Question 546** income and capital returns, interest only loan, no explanation

Which of the following statements about the capital and income returns of an **interest-only** loan is correct?

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

An interest-only loan's expected:

**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:

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

For an asset price to **triple** every **5** years, what must be the expected future capital return, given as an effective annual rate?

**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?

Which one of the below statements about effective rates and annualised percentage rates (APR's) is **NOT** correct?

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

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

**Question 538** bond pricing, income and capital returns, no explanation

Risk-free government bonds that have coupon rates greater than their yields:

Estimate the French bank Societe Generale's share price using a backward-looking price earnings (PE) multiples approach with the following assumptions and figures only. Note that EUR is the euro, the European monetary union's currency.

- The 4 major European banks Credit Agricole (ACA), Deutsche Bank AG (DBK), UniCredit (UCG) and Banco Santander (SAN) are comparable companies to Societe Generale (GLE);
- Societe Generale's (GLE's) historical earnings per share (EPS) is EUR 2.92;
- ACA's backward-looking PE ratio is 16.29 and historical EPS is EUR 0.84;
- DBK's backward-looking PE ratio is 25.01 and historical EPS is EUR 1.26;
- SAN's backward-looking PE ratio is 14.71 and historical EPS is EUR 0.47;
- UCG's backward-looking PE ratio is 15.78 and historical EPS is EUR 0.40;

Note: Figures sourced from Google Finance on 27 March 2015.

**Question 536** idiom, bond pricing, capital structure, leverage

The expression 'my word is my bond' is often used in everyday language to make a serious promise.

Why do you think this expression uses the metaphor of a bond rather than a share?

**Question 535** DDM, real and nominal returns and cash flows, stock pricing

You are an equities analyst trying to value the equity of the Australian telecoms company Telstra, with ticker TLS. In Australia, listed companies like Telstra tend to pay dividends every **6** months. The payment around August is called the final dividend and the payment around February is called the interim dividend. Both occur annually.

- Today is mid-
**March 2015**. - TLS's last interim dividend of $
**0.15**was one month ago in mid-**February 2015**. - TLS's last final dividend of $
**0.15**was seven months ago in mid-**August 2014**.

Judging by TLS's dividend history and prospects, you estimate that the nominal dividend growth rate will be **1**% pa. Assume that TLS's total nominal cost of equity is **6**% pa. The dividends are nominal cash flows and the inflation rate is **2.5**% pa. All rates are quoted as nominal effective annual rates. Assume that each month is exactly one twelfth (1/12) of a year, so you can ignore the number of days in each month.

Calculate the current TLS share price.

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

You wish to consume **half** 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.

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.

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?

**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 are promised **20** payments of $**100**, where the first payment is immediate (t=**0**) and the last is at the end of the 19th year (t=**19**). The effective annual discount rate is ##r##.

Which of the following equations does **NOT** give the correct present value of these 20 payments?

**Question 529** DDM, real and nominal returns and cash flows, inflation, real estate, no explanation

If housing rents are constrained from growing more than the maximum target inflation rate, and houses can be priced as a perpetuity of growing net rental cash flows, then what is the implication for house prices, all things remaining equal? Select the **most correct** answer.

*Background:* Since 1990, many central banks across the world have become 'inflation targeters'. They have adopted a policy of trying to keep inflation in a predictable narrow range, with the hope of encouraging long-term lending to fund more investment and maintain higher GDP growth.

Australia's central bank, the Reserve Bank of Australia (RBA), has specifically stated their inflation target range is between 2 and 3% pa.

Some Australian residential property market commentators suggest that because rental costs comprise a large part of the Australian consumer price index (CPI), rent costs across the nation cannot significantly exceed the maximum inflation target range of 3% pa without the prices of other goods growing by less than the target range for long periods, which is unlikely.

The perpetuity with growth formula, also known as the dividend discount model (DDM) or Gordon growth model, is appropriate for valuing a company's shares. ##P_0## is the current share price, ##C_1## is next year's expected dividend, ##r## is the total required return and ##g## is the expected growth rate of the dividend.

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

The below graph shows the expected future price path of the company's shares. Which of the following statements about the graph is **NOT** correct?

Total cash flows can be broken into income and capital cash flows.

What is the name given to the cash flow generated from selling shares at a higher price than they were bought?

**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 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 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 523** income and capital returns, real and nominal returns and cash flows, inflation

A low-growth mature stock has an expected nominal total return of **6**% pa and nominal capital return of **2**% pa. Inflation is expected to be **3**% pa.

All of the above are effective **nominal** rates and investors believe that they will stay the same in perpetuity.

What are the stock's expected **real** total, capital and income returns?

The answer choices below are given in the same order.

**Question 522** income and capital returns, real and nominal returns and cash flows, inflation, real estate

A residential investment property has an expected nominal total return of **6**% pa and nominal capital return of **2.5**% pa. Inflation is expected to be **2.5**% pa.

All of the above are effective **nominal** rates and investors believe that they will stay the same in perpetuity.

What are the property's expected **real** total, capital and income returns?

The answer choices below are given in the same order.

The following cash flows are expected:

- 10 yearly payments of $80, with the first payment in 6.5 years from now (first payment at t=6.5).
- A single payment of $500 in 4 years and 3 months (t=4.25) from now.

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

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?

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.

A stock **just paid** a dividend of $1. Future annual dividends are expected to grow by 2% pa. The next dividend of $1.02 (=1*(1+0.02)^1) will be in one year, and the year after that the dividend will be $1.0404 (=1*(1+0.02)^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.

A stock is expected to pay its **next** dividend of $1 in one year. Future annual dividends are expected to grow by 2% pa. So the first dividend of $1 will be in one year, the year after that $1.02 (=1*(1+0.02)^1), and a year later $1.0404 (=1*(1+0.02)^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.

Which of the following decisions relates to the current assets and current liabilities of the firm?

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

The expression 'cash is king' emphasizes the importance of having enough cash to pay your short term debts to avoid bankruptcy. Which business decision is this expression most closely related to?

**Question 513** stock split, reverse stock split, stock dividend, bonus issue, rights issue

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

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).

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

One Year Mining Project Data | ||

Project life | 1 year | |

Initial investment in building mine and equipment | $9m | |

Depreciation of mine and equipment over the year | $8m | |

Kilograms of gold mined at end of year | 1,000 | |

Sale price per kilogram | $0.05m | |

Variable cost per kilogram | $0.03m | |

Before-tax cost of closing mine at end of year | $4m | |

Tax rate | 30% | |

Note 1: Due to the project, the firm also anticipates finding some rare diamonds which will give before-tax revenues of $1m at the end of the year.

Note 2: The land that will be mined actually has thermal springs and a family of koalas that could be sold to an eco-tourist resort for an after-tax amount of $3m right now. However, if the mine goes ahead then this natural beauty will be destroyed.

Note 3: The mining equipment will have a book value of $1m at the end of the year for tax purposes. However, the equipment is expected to fetch $2.5m when it is sold.

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

Calculate the price of a newly issued **ten** year bond with a face value of $**100**, a yield of **8**% pa and a fixed coupon rate of **6**% pa, paid **semi**-annually. So there are two coupons per year, paid in arrears every six months.

Calculate the price of a newly issued **ten** year bond with a face value of $**100**, a yield of **8**% pa and a fixed coupon rate of **6**% pa, paid **annually**. So there's only one coupon per year, paid in arrears every year.

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 firm has a debt-to-equity ratio of 60%. What is its debt-to-assets ratio?

A firm has a debt-to-equity ratio of 25%. What is its debt-to-assets ratio?

A low-quality second-hand car can be bought now for $**1,000** and will last for **1** year before it will be scrapped for nothing.

A high-quality second-hand car can be bought now for $**4,900** and it will last for **5** years before it will be scrapped for nothing.

What is the equivalent annual cost of each car? Assume a discount rate of **10**% pa, given as an effective annual rate.

The answer choices are given as the equivalent annual cost of the low-quality car and then the high quality car.

Read the following financial statements and calculate the firm's free cash flow over the 2014 financial year.

UBar Corp | ||

Income Statement for | ||

year ending 30th June 2014 | ||

$m | ||

Sales | 293 | |

COGS | 200 | |

Rent expense | 15 | |

Gas expense | 8 | |

Depreciation | 10 | |

EBIT | 60 | |

Interest expense | 0 | |

Taxable income | 60 | |

Taxes | 18 | |

Net income | 42 | |

UBar Corp | ||

Balance Sheet | ||

as at 30th June | 2014 | 2013 |

$m | $m | |

Assets | ||

Cash | 30 | 29 |

Accounts receivable | 5 | 7 |

Pre-paid rent expense | 1 | 0 |

Inventory | 50 | 46 |

PPE | 290 | 300 |

Total assets | 376 | 382 |

Liabilities | ||

Trade payables | 20 | 18 |

Accrued gas expense | 3 | 2 |

Non-current liabilities | 0 | 0 |

Contributed equity | 212 | 212 |

Retained profits | 136 | 150 |

Asset revaluation reserve | 5 | 0 |

Total L and OE | 376 | 382 |

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

The firm's free cash flow over the 2014 financial year was:

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?

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?

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

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

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

For what discount rate or range of discount rates would you accept and commence the project?

All answer choices are given as approximations from reading off the graph.

Some countries' interest rates are so low that they're zero.

If interest rates are **0**% pa and are expected to stay at that level for the foreseeable future, what is the most that you would be prepared to pay a bank now if it offered to pay you $**10** at the end of every year for the next **5** years?

In other words, what is the present value of five $10 payments at time 1, 2, 3, 4 and 5 if interest rates are 0% pa?

**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 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?

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?

High risk firms in danger of bankruptcy tend to have:

**Question 494** franking credit, personal tax on dividends, imputation tax system

A firm pays a fully franked cash dividend of $**100** to one of its Australian shareholders who has a personal marginal tax rate of **15**%. The corporate tax rate is **30**%.

What will be the shareholder's personal tax payable due to the dividend payment?

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 man has taken a day off from his casual painting job to relax.

It's the end of the day and he's thinking about the hours that he could have spent working (in the past) which are now:

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 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 $**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 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 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:

A young lady is trying to decide if she should attend university. Her friends say that she should go to university because she is more likely to meet a clever young man than if she begins full time work straight away.

What's the correct way to classify this item from a capital budgeting perspective when trying to find the Net Present Value of going to university rather than working?

The opportunity to meet a desirable future spouse should be classified as:

A young lady is trying to decide if she should attend university or not.

The young lady's parents say that she must attend university because otherwise all of her hard work studying and attending school during her childhood was a waste.

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

The hard work studying at school in her childhood should be classified as:

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 approximate payout ratio over the last year?

Note that MSFT's past four quarterly dividends were $0.31, $0.28, $0.28 and $0.28.

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?

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 market capitalisation of equity?

This annuity formula ##\dfrac{C_1}{r}\left(1-\dfrac{1}{(1+r)^3} \right)## is equivalent to which of the following formulas? Note the **3**.

In the below formulas, ##C_t## is a cash flow at time t. All of the cash flows are equal, but paid at different times.

What type of present value equation is best suited to value a residential house investment property that is expected to pay **constant** rental payments **forever**? Note that 'constant' has the same meaning as 'level' in this context.

Discounted cash flow (DCF) valuation prices assets by finding the present value of the asset's future cash flows. The single cash flow, annuity, and perpetuity equations are very useful for this.

Which of the following equations is the 'perpetuity with growth' equation?

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?

An asset's total expected return over the next year is given by:

###r_\text{total} = \dfrac{c_1+p_1-p_0}{p_0} ###

Where ##p_0## is the current price, ##c_1## is the expected income in one year and ##p_1## is the expected price in one year. The total return can be split into the income return and the capital return.

Which of the following is the expected **capital** return?

The saying "buy low, sell high" suggests that investors should make a:

The below screenshot of Commonwealth Bank of Australia's (CBA) details were taken from the Google Finance website on 7 Nov 2014. Some information has been deliberately blanked out.

What was CBA's approximate payout ratio over the 2014 financial year?

Note that the firm's interim and final dividends were $**1.83** and $**2.18** respectively over the 2014 financial year.

The below screenshot of Commonwealth Bank of Australia's (CBA) details were taken from the Google Finance website on 7 Nov 2014. Some information has been deliberately blanked out.

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

The below screenshot of Commonwealth Bank of Australia's (CBA) details were taken from the Google Finance website on 7 Nov 2014. Some information has been deliberately blanked out.

What was CBA's market capitalisation of equity?

**Question 472** quick ratio, accounting ratio

A firm has current assets totaling $**1.5**b of which cash is $**0.25**b and inventories is $**0.5**b. Current liabilities total $**2**b of which accounts payable is $**1**b.

What is the firm's quick ratio, also known as the acid test ratio?

**Question 469** franking credit, personal tax on dividends, imputation tax system, no explanation

A firm pays a fully franked cash dividend of $**70** to one of its Australian shareholders who has a personal marginal tax rate of **45**%. The corporate tax rate is **30**%.

What will be the shareholder's personal tax payable due to the dividend payment?

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?

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

Which business structure or structures have the advantage of limited liability for equity investors?

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?

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):

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.

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.

**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.

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.

In Australia in the 1980's, inflation was around 8% pa, and residential mortgage loan interest rates were around 14%.

In 2013, inflation was around 2.5% pa, and residential mortgage loan interest rates were around 4.5%.

If a person can afford constant mortgage loan payments of $**2,000** per month, how much more can they borrow when interest rates are **4.5**% pa compared with **14.0**% pa?

Give your answer as a proportional increase over the amount you could borrow when interest rates were high ##(V_\text{high rates})##, so:

###\text{Proportional increase} = \dfrac{V_\text{low rates}-V_\text{high rates}}{V_\text{high rates}} ###

Assume that:

- Interest rates are expected to be constant over the life of the loan.
- Loans are
**interest-only**and have a life of**30**years. - Mortgage loan payments are made every month in arrears and all interest rates are given as annualised percentage rates (
**APR**'s) compounding per**month**.

Which of the following is **NOT** a valid method to estimate future revenues or costs in a pro-forma income statement when trying to value a company?

Which firms tend to have **low** forward-looking price-earnings (PE) ratios? Only consider firms with positive PE ratios.

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 455** income and capital returns, payout policy, DDM, market efficiency

A fairly priced **unlevered** firm plans to pay a dividend of $**1** next year (t=1) which is expected to grow by **3**% pa every year after that. The firm's required return on equity is **8**% pa.

The firm is thinking about reducing its future dividend payments by **10**% so that it can use the extra cash to invest in more projects which are expected to return **8**% pa, and have the same risk as the existing projects. Therefore, next year's dividend will be $**0.90**.

What will be the stock's new annual **capital** return (proportional increase in price per year) if the change in payout policy goes ahead?

Assume that payout policy is irrelevant to firm value and that all rates are effective annual rates.

A mining firm has just discovered a new mine. So far the news has been kept a secret.

The net present value of digging the mine and selling the minerals is $**250** million, but $**500** million of new equity and $**300** million of new bonds will need to be issued to fund the project and buy the necessary plant and equipment.

The firm will release the news of the discovery and equity and bond raising to shareholders simultaneously in the same announcement. The shares and bonds will be issued shortly after.

Once the announcement is made and the new shares and bonds are issued, what is the expected increase in the value of the firm's assets ##(\Delta V)##, market capitalisation of debt ##(\Delta D)## and market cap of equity ##(\Delta E)##? Assume that markets are semi-strong form efficient.

The triangle symbol ##\Delta## is the Greek letter capital delta which means change or increase in mathematics.

Ignore the benefit of interest tax shields from having more debt.

Remember: ##\Delta V = \Delta D+ \Delta E##

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?

**Question 452** limited liability, expected and historical returns

What is the lowest and highest expected share price and expected return from owning shares in a **company** over a finite period of time?

Let the current share price be ##p_0##, the expected future share price be ##p_1##, the expected future dividend be ##d_1## and the expected return be ##r##. Define the expected return as:

##r=\dfrac{p_1-p_0+d_1}{p_0} ##

The answer choices are stated using inequalities. As an example, the first answer choice "(a) ##0≤p<∞## and ##0≤r< 1##", states that the share price must be larger than or equal to zero and less than positive infinity, and that the return must be larger than or equal to zero and less than one.

The first payment of a constant perpetual annual cash flow is received at time 5. Let this cash flow be ##C_5## and the required return be ##r##.

So there will be equal annual cash flows at time 5, 6, 7 and so on forever, and all of the cash flows will be equal so ##C_5 = C_6 = C_7 = ...##

When the perpetuity formula is used to value this stream of cash flows, it will give a value (V) at time:

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 449** personal tax on dividends, classical tax system

A small private company has a single shareholder. This year the firm earned a $**100** profit **before** tax. All of the firm's after tax profits will be paid out as dividends to the owner.

The corporate tax rate is **30**% and the sole shareholder's personal marginal tax rate is **45**%.

The United States' **classical tax system** applies because the company generates all of its income in the US and pays corporate tax to the Internal Revenue Service. The shareholder is also an American for tax purposes.

What will be the personal tax payable by the shareholder and the corporate tax payable by the company?

**Question 448** franking credit, personal tax on dividends, imputation tax system

A small private company has a single shareholder. This year the firm earned a $**100** profit **before** tax. All of the firm's after tax profits will be paid out as dividends to the owner.

The corporate tax rate is **30**% and the sole shareholder's personal marginal tax rate is **45**%.

The Australian **imputation tax system** applies because the company generates all of its income in Australia and pays corporate tax to the Australian Tax Office. Therefore all of the company's dividends are fully franked. The sole shareholder is an Australian for tax purposes and can therefore use the franking credits to offset his personal income tax liability.

What will be the personal tax payable by the shareholder and the corporate tax payable by the company?

**Question 447** payout policy, corporate financial decision theory

Payout policy is most closely related to which part of a business?

**Question 446** working capital decision, corporate financial decision theory

The working capital decision primarily affects which part of a business?

**Question 445** financing decision, corporate financial decision theory

The financing decision primarily affects which part of a business?

**Question 444** investment decision, corporate financial decision theory

The investment decision primarily affects which part of a business?

**Question 443** corporate financial decision theory, investment decision, financing decision, working capital decision, payout policy

Business people make lots of important decisions. Which of the following is the **most** important long term decision?

**Question 442** economic depreciation, no explanation

A fairly valued share's current price is $**4** and it has a total required return of **30**%. Dividends are paid annually and next year's dividend is expected to be $1. After that, dividends are expected to grow by **5**% pa. All rates are effective annual returns.

What is the expected dividend cash flow, economic depreciation, and economic income and economic value added (EVA) that will be earned over the second year (from t=**1** to t=**2**) and paid at the end of that year (t=**2**)?

A fairly valued share's current price is $**4** and it has a total required return of **30**%. Dividends are paid annually and next year's dividend is expected to be $**1**. After that, dividends are expected to grow by **5**% pa in perpetuity. All rates are effective annual returns.

What is the expected dividend income paid at the end of the second year (t=**2**) and what is the expected capital gain from just after the first dividend (t=**1**) to just after the second dividend (t=**2**)? The answers are given in the same order, the dividend and then the capital gain.

**Question 434** Merton model of corporate debt, real option, option

A risky firm will last for one period only (t=0 to 1), then it will be liquidated. So it's assets will be sold and the debt holders and equity holders will be paid out in that order. The firm has the following quantities:

##V## = Market value of assets.

##E## = Market value of (levered) equity.

##D## = Market value of zero coupon bonds.

##F_1## = Total face value of zero coupon bonds which is promised to be paid in one year.

What is the payoff to debt holders at maturity, assuming that they keep their debt until maturity?

**Question 433** Merton model of corporate debt, real option, option, no explanation

A risky firm will last for one period only (t=0 to 1), then it will be liquidated. So it's assets will be sold and the debt holders and equity holders will be paid out in that order. The firm has the following quantities:

##V## = Market value of assets.

##E## = Market value of (levered) equity.

##D## = Market value of zero coupon bonds.

##F_1## = Total face value of zero coupon bonds which is promised to be paid in one year.

What is the payoff to equity holders at maturity, assuming that they keep their shares until maturity?

**Question 432** option, option intrinsic value, no explanation

An American call option with a strike price of ##K## dollars will mature in ##T## years. The underlying asset has a price of ##S## dollars.

What is an expression for the current **intrinsic** value in dollars from owning (being long) the American call option? Note that the intrinsic value of an option does not subtract the premium paid to buy the option.

A European put option will mature in ##T## years with a strike price of ##K## dollars. The underlying asset has a price of ##S## dollars.

What is an expression for the payoff at maturity ##(f_T)## in dollars from having written (being **short**) the put option?

A European call option will mature in ##T## years with a strike price of ##K## dollars. The underlying asset has a price of ##S## dollars.

What is an expression for the payoff at maturity ##(f_T)## in dollars from having written (being **short**) the call option?

Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $**0.5** million, but investment bank fees and integration costs with a present value of $**1.5** million is expected. A **10**% **cash** and **90**% **scrip** offer will be made that pays the fair price for the target's shares only. Assume that the Target and Acquirer agree to the deal. The cash will be paid out of the firms' cash holdings, no new debt or equity will be raised.

Firms Involved in the Takeover | ||

Acquirer | Target | |

Assets ($m) | 60 | 10 |

Debt ($m) | 20 | 2 |

Share price ($) | 10 | 8 |

Number of shares (m) | 4 | 1 |

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.

Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $**2** million. A **scrip** offer will be made that pays the fair price for the target's shares plus **70**% of the total synergy value.

Firms Involved in the Takeover | ||

Acquirer | Target | |

Assets ($m) | 60 | 10 |

Debt ($m) | 20 | 2 |

Share price ($) | 10 | 8 |

Number of shares (m) | 4 | 1 |

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.

Acquirer firm plans to launch a takeover of Target firm. The deal is expected to create a present value of synergies totaling $**2** million. A **cash** offer will be made that pays the fair price for the target's shares plus **70**% 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) | 60 | 10 |

Debt ($m) | 20 | 2 |

Share price ($) | 10 | 8 |

Number of shares (m) | 4 | 1 |

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.

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 **40**% **scrip** and **60**% **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.

Acquirer firm plans to launch a takeover of Target firm. The firms operate in different industries and the CEO's rationale for the merger is to increase diversification and thereby decrease risk. The deal is not expected to create any synergies. An **80**% scrip and **20**% cash offer will be made that pays the fair price for the target's shares. The cash will be paid out of the firms' 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 |

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 **scrip** offer will be made that pays the fair price for the target's shares plus **75**% of the total synergy value.

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 |

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 |

**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 418** capital budgeting, NPV, interest tax shield, WACC, CFFA, CAPM

Project Data | ||

Project life | 1 year | |

Initial investment in equipment | $8m | |

Depreciation of equipment per year | $8m | |

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

Unit sales per year | 4m | |

Sale price per unit | $10 | |

Variable cost per unit | $5 | |

Fixed costs per year, paid at the end of each year | $2m | |

Interest expense in first year (at t=1) | $0.562m | |

Corporate tax rate | 30% | |

Government treasury bond yield | 5% | |

Bank loan debt yield | 9% | |

Market portfolio return | 10% | |

Covariance of levered equity returns with market | 0.32 | |

Variance of market portfolio returns | 0.16 | |

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

**Notes**

- Due to the project, current assets will increase by $
**6**m now (t=0) and fall by $**6**m at the end (t=1). Current liabilities will not be affected.

**Assumptions**

- The debt-to-equity 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 project is undertaken by a firm, not an individual.

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

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

How much money do you expect to have in the fund in 40 years? Also, what is the future value of the fees that the fund expects to earn from you? Give both amounts as future values in 40 years. 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.
- The fund invests its fees in the same companies as it invests your funds in, but with no fees.

The below answer choices list your expected wealth in 40 years and then the fund's expected wealth in 40 years.

**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:

**Question 415** income and capital returns, real estate, no explanation

You just bought a residential apartment as an investment property for $**500,000**.

You intend to rent it out to tenants. They are ready to move in, they would just like to know how much the monthly rental payments will be, then they will sign a twelve-month lease.

You require a total return of **8**% pa and a rental yield of **5**% pa.

What would the monthly paid-in-advance rental payments have to be this year to receive that 5% annual rental yield?

Also, if monthly rental payments can be increased each year when a new lease agreement is signed, by how much must you increase rents per year to realise the 8% pa total return on the property?

Ignore all taxes and the costs of renting such as maintenance costs, real estate agent fees, utilities and so on. Assume that there will be no periods of vacancy and that tenants will promptly pay the rental prices you charge.

Note that the first rental payment will be received at t=0. The first lease agreement specifies the first 12 equal payments from t=0 to 11. The next lease agreement can have a rental increase, so the next twelve equal payments from t=12 to 23 can be higher than previously, and so on forever.

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?

**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 412** enterprise value, no explanation

A large proportion of a levered firm's assets is cash held at the bank. The firm is financed with half equity and half debt.

Which of the following statements about this firm's enterprise value (EV) and total asset value (V) is **NOT** 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 CAPM can be used to find a business's expected opportunity cost of capital:

###r_i=r_f+β_i (r_m-r_f)###

What should be used as the risk free rate ##r_f##?

A pharmaceutical firm has just discovered a valuable new drug. So far the news has been kept a secret.

The net present value of making and commercialising the drug is $**200** million, but $**600** million of bonds will need to be issued to fund the project and buy the necessary plant and equipment.

The firm will release the news of the discovery and bond raising to shareholders simultaneously in the same announcement. The bonds will be issued shortly after.

Once the announcement is made and the bonds are issued, what is the expected increase in the value of the firm's assets (ΔV), market capitalisation of debt (ΔD) and market cap of equity (ΔE)?

The triangle symbol is the Greek letter capital delta which means change or increase in mathematics.

Ignore the benefit of interest tax shields from having more debt.

Remember: ##ΔV = ΔD+ΔE##

**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.

**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.

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 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 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.

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

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

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

A European put option will mature in ##T## years with a strike price of ##K## dollars. The underlying asset has a price of ##S## dollars.

What is an expression for the payoff at maturity ##(f_T)## in dollars from owning (being long) the put option?

A European call option will mature in ##T## years with a strike price of ##K## dollars. The underlying asset has a price of ##S## dollars.

What is an expression for the payoff at maturity ##(f_T)## in dollars from owning (being long) the call option?

**Question 398** financial distress, capital raising, leverage, capital structure, NPV

A levered firm has zero-coupon bonds which mature in one year and have a combined face value of $**9.9**m.

Investors are risk-neutral and therefore all debt and equity holders demand the same required return of **10**% pa.

In one year the firm's assets will be worth:

- $
**13.2**m with probability 0.5 in the good state of the world, or - $
**6.6**m with probability 0.5 in the bad state of the world.

A new project presents itself which requires an investment of $**2**m and will provide a certain cash flow of $**3.3**m in one year.

The firm doesn't have any excess cash to make the initial $2m investment, but the funds can be raised from shareholders through a fairly priced rights issue. Ignore all transaction costs.

Should shareholders vote to proceed with the project and equity raising? What will be the gain in shareholder **wealth** if they decide to proceed?

**Question 397** financial distress, leverage, capital structure, NPV

A levered firm has a market value of assets of $**10**m. Its debt is all comprised of zero-coupon bonds which mature in one year and have a combined face value of $**9.9**m.

Investors are risk-neutral and therefore all debt and equity holders demand the same required return of **10**% pa.

Therefore the current market capitalisation of debt ##(D_0)## is $**9**m and equity ##(E_0)## is $**1**m.

A new project presents itself which requires an investment of $**2**m and will provide a:

- $
**6.6**m cash flow with probability 0.5 in the good state of the world, and a **-**$**4.4**m (notice the negative sign) cash flow with probability 0.5 in the bad state of the world.

The project can be funded using the company's excess cash, no debt or equity raisings are required.

What would be the new market capitalisation of equity ##(E_\text{0, with project})## if shareholders vote to proceed with the project, and therefore should shareholders proceed with the project?

Your firm's research scientists can begin an exciting new project at a cost of $**10**m now, after which there’s a:

- 70% chance that cash flows will be $
**1**m per year forever, starting in 5 years (t=**5**). This is the A state of the world. - 20% chance that cash flows will be $
**3**m per year forever, starting in 5 years (t=**5**). This is the B state of the world. - 10% chance of a major break through in which case the cash flows will be $
**20**m per year forever starting in 5 years (t=**5**), or the project can be expanded by investing another $**10**m (at t=**5**) which is expected to give cash flows of $**60**m per year forever, starting at year 9 (t=**9**). This is the C state of the world.

The firm's cost of capital is **10**% pa.

What's the present value (at t=0) of the option to expand in year 5?

The cheapest mobile phones available tend to be those that are 'locked' into a cell phone operator's network. Locked phones can not be used with other cell phone operators' networks.

Locked mobile phones are cheaper than unlocked phones because the locked-in network operator helps create a monopoly by:

Some financially minded people insist on a prenuptial agreement before committing to marry their partner. This agreement states how the couple's assets should be divided in case they divorce. Prenuptial agreements are designed to give the richer partner more of the couples' assets if they divorce, thus maximising the richer partner's:

You're thinking of starting a new cafe business, but you're not sure if it will be profitable.

You have to decide what type of cups, mugs and glasses you wish to buy. You can have your cafe's name printed on them, or plain un-marked ones. For marketing reasons it's better to have the cafe name printed, but the plain un-marked cups, mugs and glasses maximise your:

A moped is a bicycle with pedals and a little motor that can be switched on to assist the rider. Mopeds offer the rider:

One of the reasons why firms may not begin projects with relatively small positive net present values (NPV's) is because they wish to maximise the value of their:

**Question 386** Merton model of corporate debt, real option, option

A risky firm will last for one period only (t=0 to 1), then it will be liquidated. So it's assets will be sold and the debt holders and equity holders will be paid out in that order. The firm has the following quantities:

##V## = Market value of assets.

##E## = Market value of (levered) equity.

##D## = Market value of zero coupon bonds.

##F_1## = Total face value of zero coupon bonds which is promised to be paid in one year.

The risky corporate debt graph above contains bold labels a to e. Which of the following statements about those labels is **NOT** correct?

**Question 385** Merton model of corporate debt, real option, option

##V## = Market value of assets.

##E## = Market value of (levered) equity.

##D## = Market value of zero coupon bonds.

##F_1## = Total face value of zero coupon bonds which is promised to be paid in one year.

The levered equity graph above contains bold labels a to e. Which of the following statements about those labels is **NOT** correct?

Which of the following is the **least** useful method or model to calculate the value of a real option in a project?

**Question 383** Merton model of corporate debt, real option, option

In the Merton model of corporate debt, buying a levered company's debt is equivalent to buying the company's assets and:

**Question 382** Merton model of corporate debt, real option, option

In the Merton model of corporate debt, buying a levered company's shares is equivalent to:

**Question 381** Merton model of corporate debt, option, real option

In the Merton model of corporate debt, buying a levered company's debt is equivalent to buying risk free government bonds and:

One formula for calculating a levered firm's free cash flow (FFCF, or CFFA) is to use net operating profit after tax (NOPAT).

###\begin{aligned} FFCF &= NOPAT + Depr - CapEx -\Delta NWC \\ &= (Rev - COGS - Depr - FC)(1-t_c) + Depr - CapEx -\Delta NWC \\ \end{aligned} \\###

Which of the following statements is **NOT** equivalent to the **yield** on debt?

Assume that the debt being referred to is fairly priced, but do not assume that it's priced at par.

**Question 370** capital budgeting, NPV, interest tax shield, WACC, CFFA

Project Data | ||

Project life | 2 yrs | |

Initial investment in equipment | $600k | |

Depreciation of equipment per year | $250k | |

Expected sale price of equipment at end of project | $200k | |

Revenue per job | $12k | |

Variable cost per job | $4k | |

Quantity of jobs per year | 120 | |

Fixed costs per year, paid at the end of each year | $100k | |

Interest expense in first year (at t=1) | $16.091k | |

Interest expense in second year (at t=2) | $9.711k | |

Tax rate | 30% | |

Government treasury bond yield | 5% | |

Bank loan debt yield | 6% | |

Levered cost of equity | 12.5% | |

Market portfolio return | 10% | |

Beta of assets | 1.24 | |

Beta of levered equity | 1.5 | |

Firm's and project's debt-to-equity ratio |
25% | |

**Notes**

- The project will require an immediate purchase of $
**50**k of inventory, which will all be sold at cost when the project ends. Current liabilities are negligible so they can be ignored.

**Assumptions**

- The debt-to-equity 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. Note that interest expense is different in each year.
- Thousands are represented by 'k' (kilo).
- 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 nominal. 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?

One formula for calculating a levered firm's free cash flow (FFCF, or CFFA) is to use earnings before interest and tax (EBIT).

###\begin{aligned} FFCF &= (EBIT)(1-t_c) + Depr - CapEx -\Delta NWC + IntExp.t_c \\ &= (Rev - COGS - Depr - FC)(1-t_c) + Depr - CapEx -\Delta NWC + IntExp.t_c \\ \end{aligned} \\###

A method commonly seen in textbooks for calculating a levered firm's free cash flow (FFCF, or CFFA) is the following:

###\begin{aligned} FFCF &= (Rev - COGS - Depr - FC - IntExp)(1-t_c) + \\ &\space\space\space+ Depr - CapEx -\Delta NWC + IntExp(1-t_c) \\ \end{aligned}###

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}###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.

Stocks in the United States usually pay **quarterly** dividends. For example, the software giant Microsoft paid a $0.23 dividend every quarter over the 2013 financial year and plans to pay a $0.28 dividend every quarter over the 2014 financial year.

Using the dividend discount model and net present value techniques, calculate the stock price of Microsoft assuming that:

- The time now is the beginning of July 2014. The next dividend of $
**0.28**will be received in**3**months (end of September 2014), with another 3 quarterly payments of $0.28 after this (end of December 2014, March 2015 and June 2015). - The quarterly dividend will increase by
**2.5**% every year, but each quarterly dividend over the year will be equal. So each quarterly dividend paid in the financial year beginning in September 2015 will be $ 0.287 ##(=0.28×(1+0.025)^1)##, with the last at the end of June 2016. In the next financial year beginning in September 2016 each quarterly dividend will be $0.294175 ##(=0.28×(1+0.025)^2)##, with the last at the end of June 2017, 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.
- 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?

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

**Question 363** income and capital returns, inflation, real and nominal returns and cash flows, real estate

A residential investment property has an expected **nominal** total return of **8**% pa and nominal capital return of **3**% pa.

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

What are the property's expected **real** total, capital and income returns? The answer choices below are given in the same order.

Three years ago Frederika bought a house for $**400,000**.

Now it's worth $**600,000**, based on recent similar sales in the area.

Frederika's residential property has an expected **total** return of **7**% pa.

She rents her house out for $**2,500** per month, paid in advance. Every 12 months she plans to increase the rental payments.

The present value of 12 months of rental payments is $**29,089.48**.

The future value of 12 months of rental payments one year ahead is $**31,125.74**.

What is the expected annual **capital** yield of the property?

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

Ching-A-Lings Corp | ||

Income Statement for | ||

year ending 30th June 2013 | ||

$m | ||

Sales | 100 | |

COGS | 20 | |

Depreciation | 20 | |

Rent expense | 11 | |

Interest expense | 19 | |

Taxable Income | 30 | |

Taxes at 30% | 9 | |

Net income | 21 | |

Ching-A-Lings Corp | ||

Balance Sheet | ||

as at 30th June | 2013 | 2012 |

$m | $m | |

Inventory | 49 | 38 |

Trade debtors | 14 | 2 |

Rent paid in advance | 5 | 5 |

PPE | 400 | 400 |

Total assets | 468 | 445 |

Trade creditors | 4 | 10 |

Bond liabilities | 200 | 190 |

Contributed equity | 145 | 145 |

Retained profits | 119 | 100 |

Total L and OE | 468 | 445 |

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

The cash flow from assets was:

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###Estimate the Chinese bank ICBC's share price using a backward-looking price earnings (PE) multiples approach with the following assumptions and figures only. Note that the renminbi (RMB) is the Chinese currency, also known as the yuan (CNY).

- The 4 major Chinese banks ICBC, China Construction Bank (CCB), Bank of China (BOC) and Agricultural Bank of China (ABC) are comparable companies;
- ICBC 's historical earnings per share (EPS) is RMB
**0.74**; - CCB's backward-looking PE ratio is
**4.59**; - BOC 's backward-looking PE ratio is
**4.78**; - ABC's backward-looking PE ratio is also
**4.78**;

Note: Figures sourced from Google Finance on 25 March 2014. Share prices are from the Shanghai stock exchange.

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

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.

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?

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.

**Question 353** income and capital returns, inflation, real and nominal returns and cash flows, real estate

A residential investment property has an expected **nominal** total return of **6**% pa and nominal capital return of **3**% pa.

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

What are the property's expected **real** total, capital and income returns? The answer choices below are given in the same order.

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%?

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?

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:

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###Estimate the US bank JP Morgan's share price using a price earnings (PE) multiples approach with the following assumptions and figures only:

- The major US banks JP Morgan Chase (JPM), Citi Group (C) and Wells Fargo (WFC) are comparable companies;
- JP Morgan Chase's historical earnings per share (EPS) is $
**4.37**; - Citi Group's share price is $
**50.05**and historical EPS is $**4.26**; - Wells Fargo's share price is $
**48.98**and historical EPS is $**3.89**.

Note: Figures sourced from Google Finance on 24 March 2014.

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

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.

A new company's Firm Free Cash Flow (FFCF, same as CFFA) is forecast in the graph below.

To value the firm's assets, the terminal value needs to be calculated using the perpetuity with growth formula:

###V_{\text{terminal, }t-1} = \dfrac{FFCF_{\text{terminal, }t}}{r-g}###

Which point corresponds to the best time to calculate the terminal value?

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.

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 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.

**Question 338** market efficiency, CAPM, opportunity cost, technical analysis

A man inherits $**500,000** worth of shares.

He believes that by learning the secrets of trading, keeping up with the financial news and doing complex trend analysis with charts that he can quit his job and become a self-employed day trader in the equities markets.

What is the expected gain from doing this over the first year? Measure the net gain in wealth received at the end of this first year due to the decision to become a day trader. Assume the following:

- He earns $
**60,000**pa in his current job, paid in a lump sum at the end of each year. - He enjoys examining share price graphs and day trading just as much as he enjoys his current job.
- Stock markets are weak form and semi-strong form efficient.
- He has no inside information.
- He makes
**1**trade every day and there are**250**trading days in the year. Trading costs are $**20**per trade. His broker invoices him for the trading costs at the end of the year. - The shares that he currently owns and the shares that he intends to trade have the same level of systematic risk as the market portfolio.
- The market portfolio's expected return is
**10**% pa.

Measure the **net gain** over the **first** year as an expected wealth increase at the **end** of the year.

**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?

The Australian cash rate is expected to be **6**% pa while the US federal funds rate is expected to be **4**% pa over the next 3 years, both given as effective annual rates. The current exchange rate is **0.80** AUD per USD.

What is the implied **3** year forward foreign exchange rate?

**Question 335** foreign exchange rate, American and European terms

Investors expect Australia's central bank, the RBA, to reduce the policy rate at their next meeting due to fears that the economy is slowing. Then unexpectedly, the policy rate is actually kept unchanged.

What do you expect to happen to Australia's exchange rate?

When using the dividend discount model, care must be taken to avoid using a nominal dividend growth rate that exceeds the country's nominal GDP growth rate. Otherwise the firm is forecast to take over the country since it grows faster than the average business forever.

Suppose a firm's nominal dividend grows at **10**% pa forever, and nominal GDP growth is **5**% pa forever. The firm's total dividends are currently $**1** billion (t=0). The country's GDP is currently $**1,000** billion (t=0).

In approximately how many years will the company's total dividends be as large as the country's GDP?

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?

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

### p_0= \frac{c_1}{r-g} ###

Which expression is equal to the expected dividend return?

Which of the following statements about effective rates and annualised percentage rates (APR's) is **NOT** correct?

In the dividend discount model:

### P_0= \frac{d_1}{r-g} ###

The pronumeral ##g## is supposed to be the:

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?

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':

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?

**Question 323** foreign exchange rate, monetary policy, American and European terms

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

As expected, the RBA increases the policy rate by 25 basis points.

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

**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:

**Question 321** foreign exchange rate, monetary policy, American and European terms

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

Then unexpectedly, the RBA announce that they will increase the policy rate by 50 basis points due to high future GDP and inflation forecasts.

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

**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 319** foreign exchange rate, monetary policy, American and European terms

Investors expect the Reserve Bank of Australia (RBA) to keep the policy rate steady at their next meeting.

Then unexpectedly, the RBA announce that they will increase the policy rate by 25 basis points due to fears that the economy is growing too fast and that inflation will be above their target rate of 2 to 3 per cent.

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

**Question 315** foreign exchange rate, American and European terms

If the current AUD exchange rate is USD 0.9686 = AUD 1, what is the European terms quote of the AUD against the USD?

**Question 312** foreign exchange rate, American and European terms

If the current AUD exchange rate is USD 0.9686 = AUD 1, what is the American terms quote of the AUD against the USD?