Question 278 inflation, real and nominal returns and cash flows
Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year.
Question 992 inflation, real and nominal returns and cash flows
You currently have $100 in the bank which pays a 10% pa interest rate.
Oranges currently cost $1 each at the shop and inflation is 5% pa which is the expected growth rate in the orange price.
This information is summarised in the table below, with some parts missing that correspond to the answer options. All rates are given as effective annual rates. Note that when payments are not specified as real, as in this question, they're conventionally assumed to be nominal.
| Wealth in Dollars and Oranges | ||||
| Time (year) | Bank account wealth ($) | Orange price ($) | Wealth in oranges | |
| 0 | 100 | 1 | 100 | |
| 1 | 110 | 1.05 | (a) | |
| 2 | (b) | (c) | (d) | |
Which of the following statements is NOT correct? Your:
Question 993 inflation, real and nominal returns and cash flows
In February 2020, the RBA cash rate was 0.75% pa and the Australian CPI inflation rate was 1.8% pa.
You currently have $100 in the bank which pays a 0.75% pa interest rate.
Apples currently cost $1 each at the shop and inflation is 1.8% pa which is the expected growth rate in the apple price.
This information is summarised in the table below, with some parts missing that correspond to the answer options. All rates are given as effective annual rates. Note that when payments are not specified as real, as in this question, they're conventionally assumed to be nominal.
| Wealth in Dollars and Apples | ||||
| Time (year) | Bank account wealth ($) | Apple price ($) | Wealth in apples | |
| 0 | 100 | 1 | 100 | |
| 1 | 100.75 | 1.018 | (a) | |
| 2 | (b) | (c) | (d) | |
Which of the following statements is NOT correct? Your:
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.
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.
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.
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 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.
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 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 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 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 578 inflation, real and nominal returns and cash flows
Which of the following statements about inflation is NOT correct?
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?
Question 664 real and nominal returns and cash flows, inflation
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.
Question 734 real and nominal returns and cash flows, inflation, DDM, no explanation
An equities analyst is using the dividend discount model to price a company's shares. The company operates domestically and has no plans to expand overseas. It is part of a mature industry with stable positive growth prospects.
The analyst has estimated the real required return (r) of the stock and the value of the dividend that the stock just paid a moment before ##(C_\text{0 before})##.
What is the highest perpetual real growth rate of dividends (g) that can be justified? Select the most correct statement from the following choices. The highest perpetual real expected growth rate of dividends that can be justified is the country's expected:
Question 739 real and nominal returns and cash flows, inflation
There are a number of different formulas involving real and nominal returns and cash flows. Which one of the following formulas is NOT correct? All returns are effective annual rates. Note that the symbol ##\approx## means 'approximately equal to'.
Question 744 income and capital returns, real and nominal returns and cash flows, inflation
If someone says "my shares rose by 10% last year", what do you assume that they mean? The effective annual:
Question 745 real and nominal returns and cash flows, inflation, income and capital returns
If the nominal gold price is expected to increase at the same rate as inflation which is 3% pa, which of the following statements is NOT correct?
Question 1022 inflation linked bond, breakeven inflation rate, inflation, real and nominal returns and cash flows
Below is a graph of 10-year US treasury fixed coupon bond yields (red), inflation-indexed bond yields (green) and the 'breakeven' inflation rate (blue). Note that inflation-indexed bonds are also called treasury inflation protected securities (TIPS) in the US. In other countries they're called inflation-linked bonds (ILB's). For more information, see PIMCO's great article about inflation linked bonds here.
The 10 year breakeven inflation rate (blue) equals the:
Question 1023 monetary policy, inflation, breakeven inflation rate
If the breakeven inflation rate was far above the US Fed's long term 2% average inflation target, the Fed would be expected to:
Former Reserve Bank of Australia (RBA) Governor Phil Lowe says that the RBA cash rate is the interest rate in the Australian:
Former RBA Governor Phil Lowe says that if the economy is growing very strongly, then goods and services prices might be growing too:
Former RBA Governor Phil Lowe says that when the RBA raise interest rates, homeowners' mortgage loan interest expense will be:
Question 1019 RBA cash rate, monetary policy, wealth effect
Former RBA Governor Phil Lowe says that when the RBA raises the cash rate, asset prices tend to:
Question 1020 Federal funds rate, monetary policy, dot plot
US Federal Reserve Chair Jerome Powell showed the 'dot plot' of Federal Open Market Committee (FOMC) members' estimated future Fed fund rates following their quarterly summary of economic projections on 15 Dec 2021. The dot plot shows that committee members intended to make monetary policy more:
Question 1021 Federal funds rate, monetary policy, quantitative easing, tapering
US Fed Chair Jerome Powell held a news conference following the 25-26 January 2022 FOMC meeting.
Nick Timiraos reporting for The Wall Street Journal asked: "Raising rates and reducing the balance sheet both restrain the economy, both tighten monetary policy. How should we think about the relationship between the two? For example, how much passive runoff is equal to every quarter percentage point increase in your benchmark rate?"
Jerome Powell replied: "So, again, we think of the balance sheet as moving in a predictable manner, sort of in the background, and that the active tool meeting to meeting is not -- both of them, it's the federal funds rate. There are rules of thumbs. I'm reluctant to land on one of them that equate this. And there's also an element of uncertainty around the balance sheet. I think we have a much better sense, frankly, of how rate increases affect financial conditions and, hence, economic conditions. Balance sheet is still a relatively new thing for the markets and for us, so we're less certain about that." (US Fed, 2022)
When Nick Timiraos mentioned 'reducing the balance sheet', he's referring to:
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 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.
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 firms tend to have low forward-looking price-earnings (PE) ratios? Only consider firms with positive PE ratios.
A stock has a beta of 1.2. Its next dividend is expected to be $20, paid one year from now.
Dividends are expected to be paid annually and grow by 1.5% pa forever.
Treasury bonds yield 3% pa and the market portfolio's expected return is 7% pa. All returns are effective annual rates.
What is the price of the stock now?
What is the Internal Rate of Return (IRR) of the project detailed in the table below?
Assume that the cash flows shown in the table are paid all at once at the given point in time. All answers are given as effective annual rates.
| Project Cash Flows | |
| Time (yrs) | Cash flow ($) |
| 0 | -100 |
| 1 | 0 |
| 2 | 121 |
If a project's net present value (NPV) is zero, then its internal rate of return (IRR) will be:
The required return of a project is 10%, given as an effective annual rate.
What is the payback period of the project in years?
Assume that the cash flows shown in the table are received smoothly over the year. So the $121 at time 2 is actually earned smoothly from t=1 to t=2.
| Project Cash Flows | |
| Time (yrs) | Cash flow ($) |
| 0 | -100 |
| 1 | 11 |
| 2 | 121 |
A project has the following cash flows:
| Project Cash Flows | |
| Time (yrs) | Cash flow ($) |
| 0 | -400 |
| 1 | 0 |
| 2 | 500 |
What is the payback period of the project in years?
Normally cash flows are assumed to happen at the given time. But here, assume that the cash flows are received smoothly over the year. So the $500 at time 2 is actually earned smoothly from t=1 to t=2.
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.
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 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 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?
The saying "buy low, sell high" suggests that investors should make a:
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?
A share was bought for $30 (at t=0) and paid its annual dividend of $6 one year later (at t=1).
Just after the dividend was paid, the share price fell to $27 (at t=1). What were the total, capital and income returns given as effective annual rates?
The choices are given in the same order:
##r_\text{total}## , ##r_\text{capital}## , ##r_\text{dividend}##.
Question 542 price gains and returns over time, IRR, NPV, income and capital returns, effective return
For an asset price to double every 10 years, what must be the expected future capital return, given as an effective annual rate?
Question 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.
You're considering making an investment in a particular company. They have preference shares, ordinary shares, senior debt and junior debt.
Which is the safest investment? Which has the highest expected returns?
Which business structure or structures have the advantage of limited liability for equity investors?
Which of the following statements about book and market equity is NOT correct?
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 444 investment decision, corporate financial decision theory
The investment 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 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?
The expression 'you have to spend money to make money' relates to which business decision?
Question 1094 bank run, duration, no explanation
On 6 April 2023 Gillian Tett wrote: "As Powell observed: "At a basic level, Silicon Valley Bank management failed badly [because] they grew the bank very quickly, they exposed the bank to significant liquidity risk and interest rate risk, didn't hedge that risk." In plain English, the core reason a panic erupted was that SVB's balance sheet was stuffed with long-term Treasury bonds whose value has plunged in the last year as the Fed has raised rates, creating losses" (Tett, 2023).
Which of the following statements is most correct? The reason why Silicon Valley Bank (SIVB) made large losses prior to the bank run was that its assets:
Question 1035 Minsky financial instability hypothesis, leverage
Which of the following statements about 'The Financial Instability Hypothesis' (Minsky, 1992) is NOT correct? Borrowers with sufficient income to pay:
Question 1036 Minsky financial instability hypothesis, leverage
Hyman Minsky, author of 'The Financial Instability Hypothesis' (1992), wrote:
In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.
Which of the below statements explaining this quote is NOT correct?
Question 1038 fire sale, leverage, no explanation
Listen to 'Lessons and Questions from the GFC' on 6 December 2018 by RBA Deputy Governor Guy Debelle from 17:58 to 20:08 or read the below transcript:
Guy Debelle talks about the GFC and says that the Australian government’s guarantee of wholesale debt and deposits on 12 October 2008 was "introduced to facilitate the flow of credit to the real economy at a reasonable price and, in some cases, alleviate the need for asset fire sales, which have the capacity to tip markets and the economy into a worse equilibrium... The crisis very much demonstrated the critical importance of keeping the lending flowing. The lesson is that countries that did that fared better than countries that didn't. That lesson is relevant to the situation today in Australia, where there is a risk that a reduced appetite to lend will overly curtail borrowing with consequent effects for the Australian economy." (Debelle, 2019)
When assets are sold in a fire sale, there’s usually a large increase in the:
Question 1034 duration, monetary policy, inflation, market efficiency
On 18 March 2022 the AFR's James Thomson wrote: "In a world where the bombs are still falling in Ukraine and the Fed is just getting started on what looks likely to be a year-long cycle of rising interest rates, it would take a certain amount of bravery to embrace the sort of high-tech, long duration plays that Wood favours" (Thomson, 2022).
Which of the following US macro-economic data releases is most likely to cause Cathie Wood's ARK ETF share price to fall?
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':
Question 882 Asian currency crisis, foreign exchange rate, original sin, no explanation
In the 1997 Asian currency crisis, the businesses most vulnerable to bankruptcy were those that:
Question 1051 monetary policy, equilibrium real interest rate, inequality, marginal propensity to consume, gross domestic product, bond pricing
Read the below quote for background, or skip it to answer the question immediately.
In his 31 August 2021 article 'The rich get richer and rates get lower', Robert Armstrong states that:
"Atif Mian, Ludwig Straub and Amir Sufi agree with partisans of the demographic view, such as the economists Charles Goodhart and Manoj Pradhan, that a key contributor to falling rates is higher savings.
Mian, Straub and Sufi disagree, however, about why there are ever more savings sloshing around. It is not because the huge baby-boom generation is getting older and saving more (a trend that will change direction soon, when they are all retired). Rather, it’s because a larger and larger slice of national income is going to the top decile of earners. Because a person can only consume so much, the wealthy few tend to save much of this income rather than spend it. This pushes rates down directly, when those savings are invested, driving asset prices up and yields down; and indirectly, by sapping aggregate demand.
Why doesn’t all the cash that the rich push into markets get converted, ultimately, into productive investment, either at home or abroad? Tricky question. For present purposes it is enough to note that this is not happening — the savings of the American rich reappear, instead, as debt, owed by the government or by lower-income US households. (In another paper, MS&S have pointed out that this means the high share of income going to the rich hurts aggregate demand in two ways: the rich have a lower marginal propensity to consume, and governments and the non-rich are forced to shift dollars from consumption to debt service. Economically speaking, high inequality is a real buzzkill.)
MS&S prefer the inequality explanation for two reasons. Using data from the Fed’s Survey of Consumer Finances (which goes back to 1950) they show that differences in savings rates are much greater within any given age cohort than across age cohorts. That is, savings are building up faster because the rich are getting richer, not because the baby boomers are getting older."
Which of the following statements about this quote is NOT correct?
Question 1052 monetary policy, equilibrium real interest rate, marginal propensity to consume, gross domestic product, bond pricing
In the below chart by Rachel and Summers (2019), the red dotted line depicts the decline in advanced economies’ (AE) equilibrium real interest rate (R*) in percentage points since the 1970’s. The authors attribute this to the factors represented by columns above and below the x-axis. The sum of these columns is given by the black line labelled 'Total response of R* in the GE (general equilibrium) models'.
Which of the below statements about this graph is NOT correct?
Question 1039 gross domestic product, inflation, business cycle
In this business cycle graph shown in the RBA's article explaining recessions, how might 'output' on the y-axis be measured?
The ‘output’ y-axis amount in the business cycle chart can be measured by:
Question 852 gross domestic product, inflation, employment, no explanation
When the economy is booming (in an upswing), you tend to see:
Calculate Australia’s GDP over the 2016 calendar year using the below table:
| Australian Gross Domestic Product Components | ||||
| A$ billion, 2016 Calendar Year from 1 Jan 2016 to 31 Dec 2016 inclusive | ||||
| Consumption | Investment | Government spending | Exports | Imports |
| 971 | 421 | 320 | 328 | 344 |
Source: ABS 5206.0 Australian National Accounts: National Income, Expenditure and Product. Table 3. Expenditure on Gross Domestic Product (GDP), Current prices.
Over the 2016 calendar year, Australia’s GDP was:
Question 850 gross domestic product, gross domestic product per capita
Below is a table showing some countries’ GDP, population and GDP per capita.
| Countries' GDP and Population 31 December 2016 |
|||
| GDP, annual | Population | GDP per capita | |
| USD million | millions of people | USD | |
| United States | 18,036,648 | 325 | 55,492 |
| China | 11,158,457 | 1,383 | 8,066 |
| Japan | 4,383,076 | 127 | 34,586 |
| Germany | 3,363,600 | 83 | 40,623 |
| Norway | 500,519 | 5 | 95,027 |
Source: "GDP and its breakdown at current prices in US Dollars" United Nations Statistics Division. December 2016.
Using this data only, which one of these countries’ citizens have the highest living standards?
Which form of production is included in the Gross Domestic Product (GDP) reported by the government statistics agency?
An analyst is valuing a levered company whose owners insist on keeping a constant market debt to assets ratio into the future.
The analyst is wondering how asset values and other things in her model will change when she changes the forecast sales growth rate.
Which of the below values will increase as the forecast growth rate of sales increases, with the debt to assets ratio remaining constant?
Assume that the cost of debt (yield) remains constant and the company’s asset beta will also remain constant since any expansion (or downsize) will involve buying (or selling) more of the same assets.
The analyst should expect which value or ratio to increase when the forecast growth rate of sales increases and the debt to assets ratio remains unchanged? In other words, which of the following values will NOT remain constant?
Question 69 interest tax shield, capital structure, leverage, WACC
Which statement about risk, required return and capital structure is the most correct?
A firm's weighted average cost of capital before tax (##r_\text{WACC before tax}##) would increase due to:
A company has:
- 50 million shares outstanding.
- The market price of one share is currently $6.
- The risk-free rate is 5% and the market return is 10%.
- Market analysts believe that the company's ordinary shares have a beta of 2.
- The company has 1 million preferred stock which have a face (or par) value of $100 and pay a constant dividend of 10% of par. They currently trade for $80 each.
- The company's debentures are publicly traded and their market price is equal to 90% of their face value.
- The debentures have a total face value of $60,000,000 and the current yield to maturity of corporate debentures is 10% per annum. The corporate tax rate is 30%.
What is the company's after-tax weighted average cost of capital (WACC)? Assume a classical tax system.
A company issues a large amount of bonds to raise money for new projects of similar risk to the company's existing projects. The net present value (NPV) of the new projects is positive but small. Assume a classical tax system. Which statement is NOT correct?
A firm is considering a new project of similar risk to the current risk of the firm. This project will expand its existing business. The cash flows of the project have been calculated assuming that there is no interest expense. In other words, the cash flows assume that the project is all-equity financed.
In fact the firm has a target debt-to-equity ratio of 1, so the project will be financed with 50% debt and 50% equity. To find the levered value of the firm's assets, what discount rate should be applied to the project's unlevered cash flows? Assume a classical tax system.
A company has:
- 140 million shares outstanding.
- The market price of one share is currently $2.
- The company's debentures are publicly traded and their market price is equal to 93% of the face value.
- The debentures have a total face value of $50,000,000 and the current yield to maturity of corporate debentures is 12% per annum.
- The risk-free rate is 8.50% and the market return is 13.7%.
- Market analysts estimated that the company's stock has a beta of 0.90.
- The corporate tax rate is 30%.
What is the company's after-tax weighted average cost of capital (WACC) in a classical tax system?
A firm can issue 3 year annual coupon bonds at a yield of 10% pa and a coupon rate of 8% pa.
The beta of its levered equity is 2. The market's expected return is 10% pa and 3 year government bonds yield 6% pa with a coupon rate of 4% pa.
The market value of equity is $1 million and the market value of debt is $1 million. The corporate tax rate is 30%.
What is the firm's after-tax WACC? Assume a classical tax system.
A retail furniture company buys furniture wholesale and distributes it through its retail stores. The owner believes that she has some good ideas for making stylish new furniture. She is considering a project to buy a factory and employ workers to manufacture the new furniture she's designed. Furniture manufacturing has more systematic risk than furniture retailing.
Her furniture retailing firm's after-tax WACC is 20%. Furniture manufacturing firms have an after-tax WACC of 30%. Both firms are optimally geared. Assume a classical tax system.
Which method(s) will give the correct valuation of the new furniture-making project? Select the most correct answer.
A firm has a debt-to-assets ratio of 50%. The firm then issues a large amount of equity to raise money for new projects of similar systematic risk to the company's existing projects. Assume a classical tax system. Which statement is correct?
Question 1045 payout policy, leverage, capital structure, beta
A levered firm has only 2 assets on its balance sheet with the below market values and CAPM betas. The risk free rate is 3% pa and the market risk premium is 5% pa. Assume that the CAPM is correct and all assets are fairly priced.
| Balance Sheet Market Values and Betas | ||
| Balance sheet item | Market value ($m) | Beta |
| Cash asset | 0.5 | 0 |
| Truck assets | 0.5 | 2 |
| Loan liabilities | 0.25 | 0.1 |
| Equity funding | ? | ? |
The firm then pays out all of its cash as a dividend. Assume that the beta and yield on the loan liability remain unchanged. Ignore taxes, transaction costs, signalling, information asymmetries and other frictions.
Which of the following statements is NOT correct? This event led to a:
Question 1047 five Cs of credit, banking, debt terminology, Loan, credit risk, risk, leverage, financial distress
Which of the following is NOT one of the "five C's" of credit used by bankers?
A levered firm has only 2 assets on its balance sheet with the below market values and CAPM betas. The risk free rate is 3% pa and the market risk premium is 5% pa. Assume that the CAPM is correct and all assets are fairly priced.
| Balance Sheet Market Values and Betas | ||
| Balance sheet item | Market value ($m) | Beta |
| Cash asset | 0.5 | 0 |
| Truck assets | 0.5 | 2 |
| Loan liabilities | 0.25 | 0.1 |
| Equity funding | ? | ? |
The firm then pays off (retires) all of its loan liabilities using its cash. Ignore interest tax shields.
Which of the following statements is NOT correct? All answers are given to 6 decimal places. This event led to a:
An analyst has prepared a discounted cash flow model to value a firm's share price. A sensitivity analysis data table with ‘conditional formatting’ shading is shown below. The table shows how changes in the weighted average cost of capital (WACC, left column) and terminal value growth rate (top row) affect the firm's model-estimated share price.
The base case estimates are shown in bold.
Which of the following statements is NOT correct? The model-estimated share price would normally be expected to:
Question 1050 Miller debt and taxes, interest tax shields, Miller and Modigliani, no explanation
In Miller's 1977 article 'Debt and Taxes', he argues that interest tax shields are likely to benefit who? Note that this 1977 article is contrary to his past research findings with Modigliani (1958), modern textbooks and common practice by valuers.
Miller (1977) concludes that the benefits of interest tax shields are likely to benefit:
Which of the following income statement and balance sheet items should NOT be forecast using the 'percent of sales' technique?
Which of the following formulas for the carrying or net amount of 'intangible assets' such as patents from the balance sheet is correct? Assume that now is time 1 and last year is time 0, and that 'IntangibleAssets' is a carrying value net of accumulated depreciation.
Which of the following formulas for 'contributed equity' from the balance sheet is correct? Assume that now is time 1 and last year is time 0. Assume that book equity consists of contributed equity, retained profits and reserves only (BookEquity = ContributedEquity + RetainedProfits + Reserves).
Question 1058 book and market values, enterprise value, balance sheet
Here is a table from Canaccord's 'sum of the parts' valuation of INCR.
Note that the firm INCR is unlevered (interest bearing debt = 0).
The third column from the left is labelled 'Value (US$ MM)'. For the 'Israel' 410 and 'EU Export' 93 values, these are most likely to be:
The market's expected total return is 10% pa and the risk free rate is 5% pa, both given as effective annual rates.
A stock has a beta of 0.7.
In the last 5 minutes, bad economic news was released showing a higher chance of recession. Over this time the share market fell by 2%. The risk free rate was unchanged. What do you think was the stock's historical return over the last 5 minutes, given as an effective 5 minute rate?
Question 729 book and market values, balance sheet, no explanation
If a firm makes a profit and pays no dividends, which of the firm’s accounts will increase?
Question 941 negative gearing, leverage, capital structure, interest tax shield, real estate
Last year, two friends Lev and Nolev each bought similar investment properties for $1 million. Both earned net rents of $30,000 pa over the past year. They funded their purchases in different ways:
- Lev used $200,000 of his own money and borrowed $800,000 from the bank in the form of an interest-only loan with an interest rate of 5% pa.
- Nolev used $1,000,000 of his own money, he has no mortgage loan on his property.
Both Lev and Nolev also work in high-paying jobs and are subject personal marginal tax rates of 45%.
Which of the below statements about the past year is NOT correct?
Question 959 negative gearing, leverage, capital structure, interest tax shield, real estate
Last year, two friends Gear and Nogear invested in residential apartments. Each invested $1 million of their own money (their net wealth).
Apartments cost $1,000,000 last year and they earned net rents of $30,000 pa over the last year. Net rents are calculated as rent revenues less the costs of renting such as property maintenance, land tax and council rates. However, interest expense and personal income taxes are not deducted from net rents.
Gear and Nogear funded their purchases in different ways:
- Gear used $1,000,000 of her own money and borrowed $4,000,000 from the bank in the form of an interest-only loan with an interest rate of 5% pa to buy 5 apartments.
- Nogear used $1,000,000 of his own money to buy one apartment. He has no mortgage loan on his property.
Both Gear and Nogear also work in high-paying jobs and are subject personal marginal tax rates of 45%.
Which of the below statements about the past year is NOT correct?
Question 983 corporate financial decision theory, DuPont formula, accounting ratio
A company manager is thinking about the firm's book assets-to-equity ratio, also called the 'equity multiplier' in the DuPont formula:
###\text{Equity multiplier} = \dfrac{\text{Total Assets}}{\text{Owners' Equity}}###What's the name of the decision that the manager is thinking about? In other words, the assets-to-equity ratio is the main subject of what decision?
Note: DuPont formula for analysing book return on equity:
###\begin{aligned} \text{ROE} &= \dfrac{\text{Net Profit}}{\text{Sales}} \times \dfrac{\text{Sales}}{\text{Total Assets}} \times \dfrac{\text{Total Assets}}{\text{Owners' Equity}} \\ &= \text{Net profit margin} \times \text{Total asset turnover} \times \text{Equity multiplier} \\ \end{aligned}###Question 1069 Multiples valuation, venture capital, elasticity, DuPont formula, multi stage growth model
Read the below excerpt of AFR journalist Vesna Poljak's article 'What’s a start-up really worth' from 24 November 2020:
If Charlie Munger is right that earnings before interest, tax, depreciation and amortisation are “bullshit earnings”, and presenting adjusted EBITDA is “basic intellectual dishonesty”, someone should ask the 96-year-old Berkshire Hathaway vice-chairman what he thinks of revenue multiples.
It’s a necessary evil of this bull market that so many companies are now valued on multiples of their sales, as opposed to profits, typically because they don’t have any of the latter. It’s also impossible to ignore that real money investors are backing businesses at “multi-unicorn” valuations, meaning that capital is being allocated on an assumption lying somewhere between a considered ability to correctly recognise future growth, and magical thinking.
The idea is that, eventually, these businesses will arrive at a point where their constant reinvestment in sales and marketing, customer acquisition, and systems and process (all items that appear below the revenue line) will no longer be necessary, thereby allowing profits to suddenly crystallise.
Our baby unicorn is now a cloud-based workhorse with stunning margins, low operational costs, a market-dominant position and loyal customers totally insensitive to price increases.
Forecasts and evangelical founders are the natural enemies of a sound mind. “These businesses are very different compared to the typical mature business,” says PwC partner Richard Stewart. “They’re very heavily intangible-asset focused so traditional accounting doesn’t describe the performance of the business well.
“They’re also very risk intensive: it’s a bit like they’re climbing Everest, they’ve got halfway and there’s still a long way to the summit. The start-up sees how far they’ve come from base camp, the investor sees how far they have to go.”
EY partner Michael Fenech said that once upon a time, revenue multiples were used to value companies in very limited circumstances. “Now, revenue multiples have emerged as one of the primary valuation methodologies that people are using, which concerns people like myself.”
A robust valuation should be underpinned, wherever possible, by cash-flow forecasts, Fenech says. “So if we see companies relying on revenue multiples, our level of scepticism is often heightened and we start asking other questions.”
Which of the below statements is NOT correct?
A company increases the proportion of debt funding it uses to finance its assets by issuing bonds and using the cash to repurchase stock, leaving assets unchanged.
Ignoring the costs of financial distress, which of the following statements is NOT correct:
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?
Use the below information to value a levered company with constant annual perpetual cash flows from assets. The next cash flow will be generated in one year from now, so a perpetuity can be used to value this firm. Both the operating and firm free cash flows are constant (but not equal to each other).
| Data on a Levered Firm with Perpetual Cash Flows | ||
| Item abbreviation | Value | Item full name |
| ##\text{OFCF}## | $100m | Operating free cash flow |
| ##\text{FFCF or CFFA}## | $112m | Firm free cash flow or cash flow from assets (includes interest tax shields) |
| ##g## | 0% pa | Growth rate of OFCF and FFCF |
| ##\text{WACC}_\text{BeforeTax}## | 7% pa | Weighted average cost of capital before tax |
| ##\text{WACC}_\text{AfterTax}## | 6.25% pa | Weighted average cost of capital after tax |
| ##r_\text{D}## | 5% pa | Cost of debt |
| ##r_\text{EL}## | 9% pa | Cost of levered equity |
| ##D/V_L## | 50% pa | Debt to assets ratio, where the asset value includes tax shields |
| ##t_c## | 30% | Corporate tax rate |
What is the value of the levered firm including interest tax shields?
Use the below information to value a levered company with constant annual perpetual cash flows from assets. The next cash flow will be generated in one year from now, so a perpetuity can be used to value this firm. Both the operating and firm free cash flows are constant (but not equal to each other).
| Data on a Levered Firm with Perpetual Cash Flows | ||
| Item abbreviation | Value | Item full name |
| ##\text{OFCF}## | $48.5m | Operating free cash flow |
| ##\text{FFCF or CFFA}## | $50m | Firm free cash flow or cash flow from assets |
| ##g## | 0% pa | Growth rate of OFCF and FFCF |
| ##\text{WACC}_\text{BeforeTax}## | 10% pa | Weighted average cost of capital before tax |
| ##\text{WACC}_\text{AfterTax}## | 9.7% pa | Weighted average cost of capital after tax |
| ##r_\text{D}## | 5% pa | Cost of debt |
| ##r_\text{EL}## | 11.25% pa | Cost of levered equity |
| ##D/V_L## | 20% pa | Debt to assets ratio, where the asset value includes tax shields |
| ##t_c## | 30% | Corporate tax rate |
What is the value of the levered firm including interest tax shields?
Question 1032 inflation, percent of sales forecasting, no explanation
Investment bank Canaccord's Think Childcare (TNK) initiation of coverage states: "Building lease costs – Rent expense is the second largest cost and TNK reported rent/sales of 12.1%, within the industry range that we typically see as 12-14% of sales. TNK lease all their properties and do not intend to own property. Leases are generally long term with 10-15 year terms and additional options. Although terms vary across properties and landlords, rental increases are generally tied to the consumer price index (CPI)" (Canaccord, 2016).
Assuming that sales grow faster than the CPI, when Canaccord forecast TNK's building lease costs using the 'percent of sales' method, that proportion should:
View the below valuation of Dreamscape Networks by Canaccord on page 16.
Which of the below statements is NOT correct? The:
Read these quotes from Adir Shiffman's 26 July 2021 article in the AFR 'Roll up, roll up and make a mint off Amazon sellers'.
"Amazon sellers outsource their warehousing and logistics to the tech giant in a model known as “fulfilled by Amazon”, or FBA. Joining FBA provides access to one of the world’s largest global warehousing operations and even a fleet of Boeing 747 cargo jets. Just as significantly, FBA sellers can much more easily qualify for Amazon’s Prime program, which guarantees free and fast shipping to members."
"Companies want to acquire and integrate a selection, or in business parlance, do a 'roll-up'."
"More than 100 companies are now racing to roll-up FBA sellers, and almost all have launched since 2017. At least a dozen of these boast war chests of more than $US100 million. The largest, Thrasio, was founded in 2018 and has raised more than $US1.7 billion. Thrasio targets businesses with high quality and differentiated products that generate $US1 to $US100 million in revenue annually" (Shiffman, 2021).
If Thrasio's total funds available to spend on the roll up is $1.7 billion, and it's buying targets at price-to-revenue multiples of 2, what's the largest number of firms with $50 million of annual revenue that it could buy?
What proportion of managers are evaluating projects correctly, based on table 8 from Meier and Tarhan's (2006) survey of corporate managers?
| Table 8: Consistency of nominal or real hurdle rates and cash flows | |||
| Hurdle rate | Cash flows | Total | |
|---|---|---|---|
| Nominal | Real | ||
| Nominal | 29.8% | 11.6% | 41.3% |
| Real | 19.8% | 38.4% | 58.7% |
| Total | 49.6% | 50.4% | 100.0% |
Table 8 footnote: The rows in this cross-tabulation show whether the firm uses a nominal or real hurdle rate, the columns indicate whether cash flows are calculated in nominal or real terms. The fractions denote the number of firms for each combination relative to the total of 123 respondents that responded to both separate survey questions.
What proportion of managers are evaluating projects correctly?
Meier and Tarhan (2006) conducted an interesting survey of corporate managers. The results are copied in Table 7 below. What proportion of managers are evaluating levered projects correctly?
| Table 7: Consistency between hurdle rate and the calculation of cash flows | |||||||
| Hurdle rate | Cash flow calculation (see below notes) | ||||||
|---|---|---|---|---|---|---|---|
| (i) | (ii) | (iii) | (iv) | (v) | Other | Total | |
| WACC | 11.3% | 34.8% | 1.7% | 3.5% | 18.3% | 1.7% | 71.3% |
| Equity levered | 0.0% | 2.6% | 0.9% | 0.0% | 0.9% | 0.9% | 6.1% |
| Equity unlevered | 1.7% | 1.7% | 0.9% | 0.9% | 1.7% | 0.9% | 7.8% |
| Other | 2.6% | 5.2% | 1.7% | 0.9% | 3.5% | 0.9% | 14.8% |
| Total | 16.5% | 44.4% | 5.2% | 5.2% | 24.4% | 4.4% | 100.0% |
The rows of the cross-tabulation indicate what the self-reported hurdle rate represents and the columns denote five different ways to calculate cash flows, (i) to (v), plus the “other” category. Each cell then displays the fraction of all 113 respondents for a given combination of what the hurdle rate represents and how the firm calculates its cash flows when evaluating a project.
The definitions of the cash flow calculations (i)-(v) are as follows:
(i) Earnings before interest and after taxes (EBIAT) + depreciation
(ii) Earnings before interest and after taxes (EBIAT) + depreciation – capital expenditures – net change in working capital
(iii) Earnings
(iv) Earnings + depreciation
(v) Earnings + depreciation – capital expenditures – net change in working capital
Assume that the WACC is after tax, the required return on unlevered equity is the WACC before tax, all projects are levered, the benefit of interest tax shields should be included in the valuation, earnings = net profit after tax (NPAT) and EBIAT = EBIT*(1-tc) which is often also called net operating profit after tax (NOPAT).
What proportion of managers are evaluating levered projects correctly?
Question 905 market capitalisation of equity, PE ratio, payout ratio
The below graph shows the computer software company Microsoft's stock price (MSFT) at the market close on the NASDAQ on Friday 1 June 2018.
Based on the screenshot above, which of the following statements about MSFT is NOT correct? MSFT's:
Question 1013 book build, initial public offering, capital raising, demand schedule
A firm is floating its stock in an IPO and its underwriter has received the following bids, listed in order from highest to lowest share price:
| IPO Book Build Bids | ||
| Bidders | Share price | Number of shares |
| $/share | millions | |
| BidderA | 2.5 | 2 |
| BidderB | 2 | 1.5 |
| BidderC | 1.5 | 4 |
| BidderD | 1 | 3 |
| BidderE | 0.5 | 2 |
Suppose that the firm's owner wishes to sell all of their 8 million shares, so no new money will be raised and no money will re-invested back into the firm. Which of the following statements is NOT correct?
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?
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.
Question 625 dividend re-investment plan, capital raising
Which of the following statements about dividend re-investment plans (DRP's) is NOT correct?
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 firm wishes to raise $30 million now. The firm's current market value of equity is $60m and the market price per share is $20. They estimate that they'll be able to issue shares in a rights issue at a subscription price of $15. Ignore the time value of money and assume that all shareholders exercise their rights. Which of the following statements is NOT correct?
Question 803 capital raising, rights issue, initial public offering, on market repurchase, no explanation
Which one of the following capital raisings or payouts involve the sale of shares to existing shareholders only?
Question 1012 moral hazard, principal agent problem, asymmetric information
When does the ‘principal-agent problem’ occur? Is it when:
I. The principal has conflicting incentives (moral hazard);
II. The agent has conflicting incentives (moral hazard);
III. The principal has incomplete information about the agent (asymmetric information); or
IV. The agent has incomplete information about the principal (asymmetric information)?
The principal-agent problem occurs when the following statements are true:
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.
A one year European-style call option has a strike price of $4. The option's underlying stock pays no dividends and currently trades at $5. The risk-free interest rate is 10% pa continuously compounded. Use a single step binomial tree to calculate the option price, assuming that the price could rise to $8 ##(u = 1.6)## or fall to $3.125 ##(d = 1/1.6)## in one year. The call option price now is:
A one year European-style call option has a strike price of $4.
The option's underlying stock currently trades at $5, pays no dividends and its standard deviation of continuously compounded returns is 47% pa.
The risk-free interest rate is 10% pa continuously compounded.
Use the Black-Scholes-Merton formula to calculate the option price. The call option price now is:
Question 794 option, Black-Scholes-Merton option pricing, option delta, no explanation
Which of the following quantities from the Black-Scholes-Merton option pricing formula gives the Delta of a European call option?
Where:
###d_1=\dfrac{\ln[S_0/K]+(r+\sigma^2/2).T)}{\sigma.\sqrt{T}}### ###d_2=d_1-\sigma.\sqrt{T}=\dfrac{\ln[S_0/K]+(r-\sigma^2/2).T)}{\sigma.\sqrt{T}}###Question 796 option, Black-Scholes-Merton option pricing, option delta, no explanation
Which of the following quantities from the Black-Scholes-Merton option pricing formula gives the risk-neutral probability that a European call option will be exercised?
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:
Which of the following is the least useful method or model to calculate the value of a real option in a project?
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:
A moped is a bicycle with pedals and a little motor that can be switched on to assist the rider. Mopeds are useful for quick transport using the motor, and for physical exercise when using the pedals unassisted. This offers the rider:
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 pay to have your cafe's name printed on them, or just buy the 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:
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:
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: