Fight Finance

Question 857  DuPont formula, accounting ratio

The DuPont formula is:

###\dfrac{\text{Net Profit}}{\text{Sales}} \times \dfrac{\text{Sales}}{\text{Total Assets}} \times \dfrac{\text{Total Assets}}{\text{Owners' Equity}}###

Which of the following statements about the DuPont formula is NOT correct?

(a) The DuPont formula gives the book Return on Equity (ROE).

(b) The net profit to sales ratio is called the ‘gross profit margin’.

(c) The sales to total assets ratio is called the ‘total asset turnover’ ratio.

(d) The total assets to owners' equity ratio is called the ‘equity multiplier’.

(e) The equity multiplier and ROE will rise if the firm uses more leverage by replacing equity with debt.

Question 358  PE ratio, Multiples valuation

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.

(a) RMB 6.4595

(b) RMB 6.3739

(c) RMB 6.3311

(d) RMB 3.4903

(e) RMB 3.3966

Question 348  PE ratio, Multiples valuation

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.

(a) $53.2353

(b) $53.1831

(c) $53.0995

(d) $26.5498

(e) $2.7849

Question 347  PE ratio, Multiples valuation

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

(a) Common equity in small private companies.

(b) Common equity in large private companies.

(c) Common equity in listed public companies.

(d) Fixed term bonds of listed public companies.

(e) Real estate.

Question 67  CFFA, interest tax shield

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

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

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

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

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

(a) ##D(1+r_D)##

(b) ##D/(1+r_D) ##

(c) ##D.r_D ##

(d) ##D / r_D##

(e) ##NI.r_D##

Question 77  interest tax shield

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

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

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

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

(a) ##IntExp.t_c##

(b) ##IntExp/t_c##

(c) ##IntExp.(1-t_c)##

(d) ##IntExp/(1-t_c)##

(e) ##IntExp.(t_c-1)##

Question 206  CFFA, interest expense, interest tax shield

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

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

Annual interest expense is equal to:

(a) the bond's face value multiplied by its annual yield to maturity.

(b) the bond's face value multiplied by its annual coupon rate.

(c) the bond's market price at the start of the year multiplied by its annual yield to maturity.

(d) the bond's market price at the start of the year multiplied by its annual coupon rate.

(e) the future value of the actual cash payments of the bond over the year, grown to the end of the year, and grown by the bond's yield to maturity.

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?

(a) Lev’s annual interest expense would have been $40,000.

(b) Lev’s annual loss before tax on the investment property was $10,000

(c) Lev’s annual loss after tax on the investment property was $5,500

(d) Lev’s personal tax saving due to the investment property was $5,500.

(e) Nolev’s personal tax payable due to the investment property was $13,500.

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?

(a) Gear’s total annual interest expense would have been $200,000.

(b) Gear’s total annual loss before tax on the investment properties was $50,000

(c) Gear’s total annual loss after tax on the investment properties was $27,500

(d) Gear’s total personal tax saving due to the investment properties was $22,500.

(e) Nogear’s total personal tax payable due to the investment property was $16,500.

Question 375  interest tax shield, CFFA

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} \\###

Does this annual FFCF or the annual interest tax shield?

Question 367  CFFA, interest tax shield

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}###

(a) 1, 3, 5, 7, 9.

(b) 2, 4, 6, 8, 10.

(c) 1, 4, 6, 8, 10.

(d) 2, 3, 5, 7, 9.

(e) 1, 3, 5, 8, 10.

Question 88  WACC, CAPM

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) 8.40%

(b) 10.50%

(c) 10.80%

(d) 12.00%

(e) 21.00%

Question 84  WACC, capital structure, capital budgeting

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) The required return on equity, ##r_E##

(b) The required return on debt, ##r_D##

(c) The after-tax required return on debt, ##r_D.(1-t_c)##

(d) The after-tax WACC, ##\text{WACC after tax}=\frac{D}{V_L}.r_D.(1-t_c )+\frac{E_L}{V_L}.r_E##

(e) The pre-tax WACC, ##\text{WACC before tax}=\frac{D}{V_L}.r_D+\frac{E_L}{V_L}.r_E##

Question 766  CFFA, WACC, interest tax shield, DDM

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?

(a) $431.111m

(b) $444.444m

(c) $485m

(d) $515.464m

(e) $1600m

Question 303  WACC, CAPM, CFFA

There are many different ways to value a firm's assets. Which of the following will NOT give the correct market value of a levered firm's assets ##(V_L)##? Assume that:

• The firm is financed by listed common stock and vanilla annual fixed coupon bonds, which are both traded in a liquid market.
• The bonds' yield is equal to the coupon rate, so the bonds are issued at par. The yield curve is flat and yields are not expected to change. When bonds mature they will be rolled over by issuing the same number of new bonds with the same expected yield and coupon rate, and so on forever.
• Tax rates on the dividends and capital gains received by investors are equal, and capital gains tax is paid every year, even on unrealised gains regardless of when the asset is sold.
• There is no re-investment of the firm's cash back into the business. All of the firm's excess cash flow is paid out as dividends so real growth is zero.
• The firm operates in a mature industry with zero real growth.
• All cash flows and rates in the below equations are real (not nominal) and are expected to be stable forever. Therefore the perpetuity equation with no growth is suitable for valuation.

(a) ##V_L = n_\text{shares}.P_\text{share} + n_\text{bonds}.P_\text{bond}##

(b) ##V_L = n_\text{shares}.\dfrac{\text{Dividend per share}}{r_f + \beta_{EL}(r_m - r_f)} + n_\text{bonds}.\dfrac{\text{Coupon per bond}}{r_f + \beta_D(r_m - r_f)}##

(c) ##V_L = \dfrac{\text{CFFA}_{L}}{r_\text{WACC before tax}}##

(d) ##V_L = \dfrac{\text{CFFA}_{U}}{r_\text{WACC after tax}}##

(e) ##V_L = \dfrac{\text{CFFA}_{L}}{r_\text{WACC after tax}}##

Where:

###r_\text{WACC before tax} = r_D.\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L} = \text{Weighted average cost of capital before tax}### ###r_\text{WACC after tax} = r_D.(1-t_c).\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L} = \text{Weighted average cost of capital after tax}### ###NI_L=(Rev-COGS-FC-Depr-\mathbf{IntExp}).(1-t_c) = \text{Net Income Levered}### ###CFFA_L=NI_L+Depr-CapEx - \varDelta NWC+\mathbf{IntExp} = \text{Cash Flow From Assets Levered}### ###NI_U=(Rev-COGS-FC-Depr).(1-t_c) = \text{Net Income Unlevered}### ###CFFA_U=NI_U+Depr-CapEx - \varDelta NWC= \text{Cash Flow From Assets Unlevered}###

Question 773  CFFA, WACC, interest tax shield, DDM

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?

(a) $515.464m

(b) $500m

(c) $485m

(d) $444.444m

(e) $431.111m

Question 804  CFFA, WACC, interest tax shield, DDM

Use the below information to value a levered company with annual perpetual cash flows from assets that grow. The next cash flow will be generated in one year from now. Note that ‘k’ means kilo or 1,000. So the $30k is $30,000.

Data on a Levered Firm with Perpetual Cash Flows
Item abbreviation	Value	Item full name
##\text{OFCF}##	$30k	Operating free cash flow
##g##	1.5% pa	Growth rate of OFCF
##r_\text{D}##	4% pa	Cost of debt
##r_\text{EL}##	16.3% pa	Cost of levered equity
##D/V_L##	80% pa	Debt to assets ratio, where the asset value includes tax shields
##t_c##	30%	Corporate tax rate
##n_\text{shares}##	100k	Number of shares

 

Which of the following statements is NOT correct?

(a) The WACC before tax is 6.46% pa.

(b) The WACC after tax is 5.50% pa.

(c) The current levered asset value including tax shields is $603.839k.

(d) The current debt value is $600k and the interest tax shield benefit over the first year is $7.2k (at t=1).

(e) The current share price is $1.50.

Question 504  CFFA

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) $51

(b) $52

(c) $58

(d) $61

(e) $62

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

1. Due to the project, current assets will increase by $6m now (t=0) and fall by $6m 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) $5.772m

(b) $4.979m

(c) $4.959m

(d) $4.733m

(e) $4.584m

Question 470  accounting ratio, no explanation

Which of the following statements is NOT correct?

(a) A firm's quick ratio will always be equal to or less than its current ratio.

(b) A firm will have positive net working capital if it has a current ratio that's greater than one.

(c) A firm's gross margin will be greater than or equal to its operating margin, which will be greater than or equal to its net profit margin.

(d) A firm's fixed asset turnover will be less than or equal to asset turnover.

(e) A firm's debt to equity ratio will always be greater than or equal to its debt to assets ratio.

Question 471  risk, accounting ratio

High risk firms in danger of bankruptcy tend to have:

(a) Low debt to assets ratios.

(b) High quick ratios.

(c) Low interest coverage ratios.

(d) Positive amounts of net working capital.

(e) High net profit margins.

Question 472  quick ratio, accounting ratio

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

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

(a) 0%

(b) 25%

(c) 50%

(d) 75%

(e) 100%

Question 490  expected and historical returns, accounting ratio

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

(a) total required yield

(b) cost of capital

(c) discount rate

(d) opportunity cost of capital

(e) accounting rate of return

Question 495  risk, accounting ratio, no explanation

High risk firms in danger of bankruptcy tend to have:

(a) Low debt to assets ratios.

(b) Low quick ratios.

(c) High interest coverage ratios.

(d) Positive amounts of net working capital.

(e) High net profit margins.

Question 506  leverage, accounting ratio

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

(a) 20%

(b) 36%

(c) 60%

(d) 75%

(e) 93.75%

Question 507  leverage, accounting ratio

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

(a) 64%

(b) 40%

(c) 37.5%

(d) 25%

(e) 6.25%

Question 799  LVR, leverage, accounting ratio

In the home loan market, the acronym LVR stands for Loan to Valuation Ratio. If you bought a house worth one million dollars, partly funded by an $800,000 home loan, then your LVR was 80%. The LVR is equivalent to which of the following ratios?

(a) Debt to equity ratio.

(b) Debt to assets ratio.

(c) Book to market ratio.

(d) Price to earnings ratio.

(e) Interest coverage ratio.

Question 68  WACC, CFFA, capital budgeting

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

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

(a) The manufacturing firm's before-tax WACC.

(b) The manufacturing firm's after-tax WACC.

(c) A services firm's before-tax WACC, assuming that the services firm has the same debt-to-assets ratio as the manufacturing firm.

(d) A services firm's after-tax WACC, assuming that the services firm has the same debt-to-assets ratio as the manufacturing firm.

(e) The services firm's levered cost of equity.

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

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

(a) The before-tax cost of debt is less than the before-tax cost of equity. Therefore debt is a cheaper form of financing than equity so companies should try to finance their projects with debt only.

(b) Debt makes a firm's equity more risky. Therefore the higher the amount of debt, the higher the cost of equity.

(c) The more debt a firm has, the higher its tax shields. Therefore firms should seek to have as much debt and as little equity as possible.

(d) The more debt, the lower the firm's after tax WACC. The after tax WACC is the discount rate that discounts the firm's cash flows, so the lower it is the more the firm is worth. Therefore firms should try to make their after tax WACC as low as possible by using as much debt as possible.

(e) The less debt, the lower the chance of bankruptcy. Therefore firms should try to pay off all of their debt so that they are financed by equity only.

Question 74  WACC, capital structure, CAPM

A firm's weighted average cost of capital before tax (##r_\text{WACC before tax}##) would increase due to:

(a) The firm issuing more debt and using the proceeds to repurchase stock.

(b) The firm issuing more equity and using the proceeds to pay off debt holders.

(c) The firm's industry becoming more systematically risky, for example if it was a mining company whose performance became more sensitive to countries' GDP growth, so the correlation of the firm's returns with the market was higher.

(d) The firm's industry becoming less systematically risky, for example if it was a child care centre and the government announced higher subsidies for parents using child care centres, so the correlation of the firm's returns with the market was lower.

(e) None of the above.

Question 78  WACC, capital structure

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) The debt-to-assets (D/V) ratio will increase.

(b) The debt-to-equity ratio (D/E) will increase.

(c) Firm value is likely to have increased due to the higher amount of interest tax shields, assuming that there will not be any costs of financial distress.

(d) The company's after-tax WACC is likely to have decreased.

(e) The company's before-tax WACC is likely to have decreased.

Question 85  WACC, CAPM

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) 13.18%

(b) 11.10%

(c) 12.50%

(d) 14.24%

(e) 15.00%

Question 91  WACC, capital structure

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?

(a) The debt-to-assets (D/V) ratio will increase.

(b) The debt-to-equity ratio (D/E) will increase.

(c) Firm value is likely to have increased due to the higher amount of interest tax shields, assuming that there will not be any costs of financial distress.

(d) The company's after-tax WACC is likely to stay the same.

(e) The company's before-tax WACC is likely to stay the same.

Question 113  WACC, CFFA, capital budgeting

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

Assume the following:

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

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

The mobile phone manufacturing project's:

(a) Unlevered CFFA should be discounted by Google's 10% WACC after tax.

(b) Unlevered CFFA should be discounted by Motorola's 20% WACC after tax.

(c) Levered CFFA should be discounted by Google's 10% WACC after tax.

(d) Levered CFFA should be discounted by Motorola's 20% WACC after tax.

(e) Unlevered CFFA by 15%, the average of Google and Motorola's WACC after tax.

Question 173  CFFA

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

Candys Corp
Income Statement for
year ending 30th June 2013
	$m
Sales	200
COGS	50
Operating expense	10
Depreciation	20
Interest expense	10
Income before tax	110
Tax at 30%	33
Net income	77

Candys Corp
Balance Sheet
as at 30th June	2013	2012
	$m	$m
Assets
Current assets	220	180
PPE
Cost	300	340
Accumul. depr.	60	40
Carrying amount	240	300
Total assets	460	480
Liabilities
Current liabilities	175	190
Non-current liabilities	135	130
Owners' equity
Retained earnings	50	60
Contributed equity	100	100
Total L and OE	460	480

 

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

(a) 242

(b) 182

(c) 112

(d) 92

(e) 52

Question 176  CFFA

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

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

(a) CapEx is added in the Net Income (NI) equation so it needs subtracting in the CFFA equation.

(b) CapEx is a financing cash flow that needs to be ignored. Therefore it should be subtracted.

(c) CapEx is not a cash flow, it's a non-cash expense made up by accountants that needs to be subtracted.

(d) CapEx is subtracted to account for the net cash spent on capital assets.

(e) CapEx is subtracted because it's too hard to predict, therefore we exclude it.

Question 188  CFFA

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

Trademark Corp
Income Statement for
year ending 30th June 2013
	$m
Sales	100
COGS	25
Operating expense	5
Depreciation	20
Interest expense	20
Income before tax	30
Tax at 30%	9
Net income	21

Trademark Corp
Balance Sheet
as at 30th June	2013	2012
	$m	$m
Assets
Current assets	120	80
PPE
Cost	150	140
Accumul. depr.	60	40
Carrying amount	90	100
Total assets	210	180
Liabilities
Current liabilities	75	65
Non-current liabilities	75	55
Owners' equity
Retained earnings	10	10
Contributed equity	50	50
Total L and OE	210	180

 

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

(a) -19

(b) 21

(c) 41

(d) 61

(e) 121

Question 208  CFFA

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

UniBar Corp
Income Statement for
year ending 30th June 2013
	$m
Sales	80
COGS	40
Operating expense	15
Depreciation	10
Interest expense	5
Income before tax	10
Tax at 30%	3
Net income	7

UniBar Corp
Balance Sheet
as at 30th June	2013	2012
	$m	$m
Assets
Current assets	120	90
PPE
Cost	360	320
Accumul. depr.	40	30
Carrying amount	320	290
Total assets	440	380
Liabilities
Current liabilities	110	60
Non-current liabilities	190	180
Owners' equity
Retained earnings	95	95
Contributed equity	45	45
Total L and OE	440	380

 

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

(a) 12

(b) 2

(c) -8

(d) -18

(e) 48

Question 223  CFFA, interest tax shield

Which one of the following will increase the Cash Flow From Assets in this year for a tax-paying firm, all else remaining constant?

(a) An increase in net capital spending.

(b) A decrease in the cash flow to creditors.

(c) An increase in interest expense.

(d) An increase in net working capital.

(e) A decrease in dividends paid.

Question 225  CFFA

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

(a) Buy less land, buildings and trucks than what was planned. Assume that this has no impact on revenue.

(b) Pay off more debt than was planned, to reduce the firm’s interest expense.

(c) Change the depreciation method used for tax purposes from diminishing value to straight line, so less depreciation occurs this year and more occurs in later years. Assume that the government’s tax department allow this.

(d) Buying more inventory than was planned, so there is an increase in net working capital. Assume that there is no increase in sales.

(e) Raising new equity through a rights issue. Assume that all of the money raised is spent on new capital assets such as land and trucks, but they will be fitted out and delivered in one year so no new cash will be earned from them.

Question 238  CFFA, leverage, interest tax shield

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) The company is increasing its debt-to-assets and debt-to-equity ratios. These are types of 'leverage' or 'gearing' ratios.

(b) The company will pay less tax to the government due to the benefit of interest tax shields.

(c) The company's net income, also known as earnings or net profit after tax, will fall.

(d) The company's expected levered firm free cash flow (FFCF or CFFA) will be higher due to tax shields.

(e) The company's expected levered equity free cash flow (EFCF) will not change.

Question 296  CFFA, interest tax shield

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 - ΔNWC+IntExp###

(a) An increase in revenue (##Rev##).

(b) An decrease in revenue (##Rev##).

(c) An increase in rent expense (part of fixed costs, ##FC##).

(d) An increase in interest expense (##IntExp##).

(e) An increase in dividends.

Question 342  CFFA, capital budgeting

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?

(a) Point A.

(b) Point B.

(c) Point C.

(d) Any of the points.

(e) None of the points.

Question 343  CFFA, capital budgeting

An old 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?

(a) Point A.

(b) Point B.

(c) Point C.

(d) Any of the points.

(e) None of the points.

Question 349  CFFA, depreciation tax shield

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###

(a) An increase in revenue (Rev).

(b) An increase in rent expense (part of fixed costs, FC).

(c) An increase in depreciation expense (Depr).

(d) An decrease in net working capital (ΔNWC).

(e) An increase in dividends.

Question 350  CFFA

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
Cash	0	0
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:

(a) $138m

(b) $142m

(c) $143m

(d) $172m

(e) $176m

Question 359  CFFA

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###

(a) An increase in revenue (Rev).

(b) An increase in rent expense (a type of recurring fixed cost, FC).

(c) An increase in depreciation expense (Depr).

(d) An increase in inventories (a current asset).

(e) An decrease in interest expense (IntExp).

Question 361  CFFA

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

• Make $5m in sales, $1.9m in net income and $2m in equity free cash flow (EFCF).
• Pay dividends of $1m.
• Complete a $1.3m 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?

(a) $2m

(b) $1m

(c) $0.4m

(d) $0.3m

(e) No new shares need to be issued, the firm will be sufficiently financed.

Question 366  opportunity cost, NPV, CFFA

Your friend is trying to find the net present value of an investment which:

• Costs $1 million initially (t=0); and
• Pays a single positive cash flow of $1.1 million in one year (t=1).

The investment 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.

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

Method 2: ##-1m + 1.1m - 1m \times 0.1 ##

Method 3: ##-1m + \dfrac{1.1m}{(1+0.1)^1} - 1m \times 0.1 ##

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

(a) Method 1 only.

(b) Method 2 only.

(c) Method 3 only.

(d) Methods 1 and 2 only.

(e) Methods 1 and 3 only.

Question 369  interest tax shield, CFFA

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} \\###

Does this annual FFCF or the annual interest tax shield?

Question 401  capital budgeting, CFFA

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

(a) Diversifiable standard deviation of asset returns.

(b) Systematic standard deviation of asset returns.

(c) Proportion of debt and equity used to fund the assets.

(d) Cash flows from assets.

(e) Risk free rate.

Question 413  CFFA, interest tax shield, depreciation tax shield

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

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

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

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

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

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

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

(a) ##FFCF=EBITDA+ Depr - CapEx -ΔNWC + IntExp##

(b) ##FFCF=EBITDA.(1-t_c )+Depr- CapEx -ΔNWC##

(c) ##FFCF=EBITDA.(1-t_c )+ Depr.t_c - CapEx -ΔNWC + IntExp.t_c##

(d) ##FFCF=EBITDA.(1-t_c )+Depr.(1-t_c )- CapEx -ΔNWC+IntExp.(1-t_c)##

(e) ##FFCF=EBITDA.(1-t_c )- CapEx -ΔNWC##

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

1. Due to the project, current assets will increase by $5m now (t=0) and fall by $5m 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?

(a) $7.33k

(b) $7.299k

(c) $6.946k

(d) $6.729k

(e) $6.667k

Question 619  CFFA

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) Net income, depreciation and interest expense.

(b) Depreciation and capital expenditure.

(c) Current assets, current liabilities and cost of goods sold (COGS).

(d) Current assets, current liabilities and capital expenditure.

(e) Current assets, current liabilities and depreciation expense.

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.

(a) Net income, depreciation and interest expense.

(b) Depreciation and capital expenditure.

(c) Current assets and current liabilities.

(d) Current assets, current liabilities and capital expenditure.

(e) Current assets, current liabilities and depreciation expense.

Question 555  capital budgeting, CFFA

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).

(a) -48,   54.5,   55.8

(b) -48,   54.5,   74.5

(c) -48,   74.5,   35.8

(d) -48,   74.5,   75.8

(e) -8,   74.5,   75.8

Question 987  interest tax shield, capital structure, debt terminology

What creates interest tax shields for a company?

(a) Debt assets.

(b) Debt funding.

(c) Equity assets.

(d) Equity funding.

(e) None of the above.

Question 457  PE ratio, Multiples valuation

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

(a) Highly liquid publically listed firms.

(b) Firms in a declining industry with very low or negative earnings growth.

(c) Firms expected to have temporarily low earnings over the next year, but with higher earnings later.

(d) Firms whose returns have a very low level of systematic risk.

(e) Firms whose assets include a very large proportion of cash.

Question 537  PE ratio, Multiples valuation, no explanation

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.

(a) EUR 209.6268

(b) EUR 52.4067

(c) EUR 8.6724

(d) EUR 3.9327

(e) EUR 2.1681

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:

(a) Equal the inverse of the firm's nominal income return.

(b) Equal the inverse of the firm's real total return.

(c) Equal the inverse of the firm's real capital return.

(d) Equal the expected payback period of an investor who intends to buy the firm's equity at the current price.

(e) Be lower than that of faster growing firms that pay lower dividends and re-invest in themselves.

Note: The inverse of x is 1/x.

Question 129  debt terminology

An 'interest rate' is the same thing as a 'coupon rate'. or ?

Question 23  bond pricing, premium par and discount bonds

Bonds X and Y are issued by the same US company. Both bonds yield 10% pa, and they have the same face value ($100), maturity, seniority, and payment frequency.

The only difference is that bond X and Y's coupon rates are 8 and 12% pa respectively. Which of the following statements is true?

(a) Bonds X and Y are premium bonds.

(b) Bonds X and Y are discount bonds.

(c) Bond X is a discount bond but bond Y is a premium bond.

(d) Bond X is a premium bond but bond Y is a discount bond.

(e) Bonds X and Y are par bonds.

Question 476  income and capital returns, idiom

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

(a) Positive income return.

(b) Positive capital return.

(c) Negative income return.

(d) Negative capital return.

(e) Positive total return.

Question 477  income and capital returns

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) ##c_1##

(b) ##p_1-p_0##

(c) ##\dfrac{c_1}{p_0} ##

(d) ##\dfrac{p_1}{p_0} -1##

(e) ##\dfrac{p_1}{p_0} ##

Question 478  income and capital returns

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

(a) Dividends.

(b) Rent.

(c) Coupons.

(d) Loan payments.

(e) Capital gains.

Question 508  income and capital returns

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

(b) ##r_\text{total} = \dfrac{c_1+p_1}{p_0} - 1##

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

(d) ##r_\text{total} = \dfrac{c_1}{p_0} + \dfrac{p_1}{p_0} ##

(e) ##r_\text{total} = \dfrac{c_1}{p_0} + \dfrac{p_1}{p_0} - 1##

Question 136  income and capital returns

A stock was bought for $8 and paid a dividend of $0.50 one year later (at t=1 year). Just after the dividend was paid, the stock price was $7 (at t=1 year).

What were the total, capital and dividend returns given as effective annual rates? The choices are given in the same order:

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

(a) 0.0625, -0.0625, -0.125.

(b) 0.0625, 0.125, -0.0625.

(c) -0.0625, 0.0625, -0.125.

(d) -0.0625, -0.125, 0.0625.

(e) -0.125, -0.1875, 0.0625.

Question 870  income and capital returns

An Apple (NASDAQ:AAPL) stock was purchased by an investor for $120 and one year later was sold for $150. A dividend of $4 was also collected at the end of the year just before the stock was sold.

Which of the following statements about the stock investment is NOT correct? Ignore taxes.

Over the year, the investor made a:

(a) Capital gain of $30

(b) Dividend income of $4.

(c) Capital return of 25%.

(d) Dividend yield of 2.6667%.

(e) Total return of 28.3333%.

.

Question 915  price gains and returns over time, IRR, NPV, income and capital returns, effective return

For a share price to double over 7 years, what must its capital return be as an effective annual rate?

(a) 9.9021%

(b) 9.9431%

(c) 10.4090%

(d) 28.5714%

(e) 100%

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.

After one year, would you be able to buy , exactly the as or than today with the money in this account?

Question 728  inflation, real and nominal returns and cash flows, income and capital returns, no explanation

Which of the following statements about gold is NOT correct? Assume that the gold price increases by inflation. Gold has a:

(a) Nil income cash flow.

(b) Real total return of zero.

(c) Real capital return equal to the inflation rate.

(d) Real income return of zero.

(e) Nominal income return of zero.

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

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

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

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

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

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

Which of the above statements is or are correct?

(a) I only.

(b) III only.

(c) IV only.

(d) I and IV only.

(e) II and III only.

Question 456  inflation, effective rate

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

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

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

The answer choices below are given as effective annual rates:

(a) 0.5086% pa

(b) 1.5086% pa

(c) 5.0859% pa

(d) 50.8591% pa

(e) 150.8591% pa

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.

(a) 3.9216%, 2.9412%, 0.9804%.

(b) 3.9216%, 0.9804%, 2.9412%.

(c) 3.9216%, 0.9804%, 0.9804%.

(d) 1.9804%, 1.0000%, 0.9804%.

(e) 1.9608%, 0.9804%, 0.9804%.

Question 867  limited liability, business structure

Which one of the following businesses is likely to be a public company in Australia, judging by its name?

(a) Joe Bloggs

(b) Jane Doe

(c) Bloggs and Doe

(d) Bloggs Ltd

(e) Doe Pty Ltd

Question 466  limited liability, business structure

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

(a) Sole traders.

(b) Partnerships.

(c) Corporations.

(d) All of the above.

(e) None of the above

Question 120  credit risk, payout policy

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

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

(a) Preferred stock only.

(b) The senior and junior bonds only.

(c) Common stock only.

(d) The senior and junior bonds and the preferred stock.

(e) No payments on any security is required since the firm made a loss.

Question 221  credit risk

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?

(a) Junior debt is the safest. Preference shares have the highest expected returns.

(b) Preference shares are the safest. Ordinary shares have the highest expected returns.

(c) Senior debt is the safest. Ordinary shares have the highest expected returns.

(d) Junior debt is the safest. Ordinary shares have the highest expected returns.

(e) Senior debt is the safest. Junior debt have the highest expected returns.

Question 447  payout policy, corporate financial decision theory

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

(a) Assets.

(b) Liabilities and owner's equity.

(c) Current assets and current liabilities.

(d) Dividends and buy backs.

(e) Net income, also known as earnings or net profit after tax.

Question 445  financing decision, corporate financial decision theory

The financing decision primarily affects which part of a business?

(a) Assets.

(b) Liabilities and owner's equity.

(c) Current assets and current liabilities.

(d) Dividends and buy backs.

(e) Net income, also known as earnings or net profit after tax.

Question 446  working capital decision, corporate financial decision theory

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

(a) Assets.

(b) Liabilities and owner's equity.

(c) Current assets and current liabilities.

(d) Dividends and buy backs.

(e) Net income, also known as earnings or net profit after tax.

Question 444  investment decision, corporate financial decision theory

The investment decision primarily affects which part of a business?

(a) Assets.

(b) Liabilities and owner's equity.

(c) Current assets and current liabilities.

(d) Dividends and buy backs.

(e) Net income, also known as earnings or net profit after tax.

Question 514  corporate financial decision theory, idiom

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?

(a) Investment decision.

(b) Financing decision.

(c) Working capital decision.

(d) Payout policy decision.

(e) Capital or labour decision.

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?

(a) Asset revaluation reserve.

(b) Foreign currency translation reserve.

(c) Retained earnings, also known as retained profits.

(d) Contributed equity, also known as paid up capital.

(e) General reserve.

Question 473  market capitalisation of equity

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?

(a) $431.18 billion

(b) $429 billion

(c) $134.07 billion

(d) $8.44 billion

(e) $3.21 billion

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.

(a) 5.8824%, 0.9804%, 4.902%.

(b) 5.8824%, 0.9804%, 2.9412%.

(c) 4.0000%, 1.0000%, 3.0000%.

(d) 3.9412%, 1.0000%, 2.9412%.

(e) 3.9216%, 0.9804%, 2.9412%.

Question 467  book and market values

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

(a) The market value of equity of a listed company's common stock is equal to the number of common shares multiplied by the share price.

(b) The book value of equity is the sum of contributed equity, retained profits and reserves.

(c) A company's book value of equity is recorded in its income statement, also known as the 'profit and loss' or the 'statement of financial performance'.

(d) A new company's market value of equity equals its book value of equity the moment that its shares are first sold. From then on, the market value changes continuously but the book value is recorded at historical cost which typically only changes due to retained profits.

(e) To buy all of the firm's shares, generally a price close to the market value of equity will have to be paid.

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.

(a) The book value of equity would be larger than the market value of equity.

(b) The book ROA from accounting would be larger than the required return on assets from finance.

(c) The book ROE from accounting would be larger than the required return on equity from finance.

(d) The book ROE would be larger than the book ROA.

(e) The required return on equity would be larger than the required return on assets.

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.

Question 217  NPV, DDM, multi stage growth model

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

What is the price of the stock now?

(a) $361.78

(b) $236.33

(c) $237.93

(d) $348.69

(e) $223.24

Question 333  DDM, time calculation

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?

(a) 1,443 years

(b) 1,199 years

(c) 955 years

(d) 674 years

(e) 148 years

Question 270  real estate, DDM, effective rate conversion

You own an apartment which you rent out as an investment property.

What is the price of the apartment using discounted cash flow (DCF, same as NPV) valuation?

Assume that:

• You just signed a contract to rent the apartment out to a tenant for the next 12 months at $2,000 per month, payable in advance (at the start of the month, t=0). The tenant is just about to pay you the first $2,000 payment.
• The contract states that monthly rental payments are fixed for 12 months. After the contract ends, you plan to sign another contract but with rental payment increases of 3%. You intend to do this every year.
  So rental payments will increase at the start of the 13th month (t=12) to be $2,060 (=2,000(1+0.03)), and then they will be constant for the next 12 months.
  Rental payments will increase again at the start of the 25th month (t=24) to be $2,121.80 (=2,000(1+0.03)²), and then they will be constant for the next 12 months until the next year, and so on.
• The required return of the apartment is 8.732% pa, given as an effective annual rate.
• Ignore all taxes, maintenance, real estate agent, council and strata fees, periods of vacancy and other costs. Assume that the apartment will last forever and so will the rental payments.

(a) $415,149.4048

(b) $438,252.6707

(c) $441,067.7356

(d) $444,155.5276

(e) $455,263.0844

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

Fill in the missing words in the following sentence:

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

(a) Fall, fall.

(b) Fall, rises.

(c) Rise, fall.

(d) Rise, rise.

(e) Remain unchanged, remain unchanged.

Question 657  systematic and idiosyncratic risk, CAPM, no explanation

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

(a) Systematic risk increases.

(b) Idiosyncratic risk increases.

(c) Total risk increases.

(d) Systematic risk decreases.

(e) Idiosyncratic risk decreases.

Question 988  variance, covariance, beta, CAPM, risk, no explanation

Price Data Time Series
Sourced from Yahoo Finance Historical Price Data
Date	S&P500 Index (^GSPC)						Apple (AAPL)
	Open	High	Low	Close	Adj close		Open	High	Low	Close	Adj close
2007, Wed 3 Jan	1418	1429	1408	1417	1417		12.33	12.37	11.7	11.97	10.42
2008, Wed 2 Jan	1468	1472	1442	1447	1447		28.47	28.61	27.51	27.83	24.22
2009, Fri 2 Jan	903	935	899	932	932		12.27	13.01	12.17	12.96	11.28
2010, Mon 4 Jan	1117	1134	1117	1133	1133		30.49	30.64	30.34	30.57	26.6
Source: Yahoo Finance.

 

Which of the following statements about the above table which is used to calculate Apple's equity beta is NOT correct?

(a) Adjusted closing prices add back dividends and reverse the effect of stock splits.

(b) Apple's effective annual total return between the market close on 2 January 2008 and 2 January 2009 was -0.534269 (=(24.22-11.28)/24.22).

(c) Sample variance of the S&P500's effective annual total returns over the 3 year period was 0.084452.

(d) Sample covariance of effective total annual returns between Apple and the S&P500 index over the 3 year period was 0.041131.

(e) Apple's equity beta of annual total returns over the 3 year period was 3.530767.

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.

(a) $795.62

(b) $792.0937

(c) $735.0299

(d) $731.7721

(e) $683.0135

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.

(a) $472.3557

(b) $471.298

(c) $436.7194

(d) $435.7415

(e) $405.8112

Question 578  inflation, real and nominal returns and cash flows

Which of the following statements about inflation is NOT correct?

(a) Real returns approximately equal nominal returns less the inflation rate.

(b) Constant prices are the same as real prices.

(c) Current prices are the same as nominal prices.

(d) If your nominal wage grows by inflation, then your real wage won't change because you will be able to buy the same amount of goods and services as before.

(e) Interest rates advertised at the bank are usually quoted in real 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) A payment of $105 now has a real value of 105 apples or oranges now.

(b) A payment of $1 now has a real value of one apple or orange now.

(c) A payment of $105 in one year has a real value of 100 apples or oranges in one year.

(d) A payment of $105 in one year is worth $105 in real terms today.

(e) A payment of one apple now has a real value of one orange now.

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) $3,466.6667

(b) $3,333.3333

(c) $3,205.1282

(d) $1,485.7143

(e) $1,428.5714

Question 727  inflation, real and nominal returns and cash flows

The Australian Federal Government lends money to domestic students to pay for their university education. This is known as the Higher Education Contribution Scheme (HECS). The nominal interest rate on the HECS loan is set equal to the consumer price index (CPI) inflation rate. The interest is capitalised every year, which means that the interest is added to the principal. The interest and principal does not need to be repaid by students until they finish study and begin working.

Which of the following statements about HECS loans is NOT correct?

(a) The real interest rate is zero.

(b) The nominal amount owing on the loan will increase at the inflation rate over time, if there are no extra payments or borrowings.

(c) The real amount owing on the loan in today's money will remain the same over time, if there are no extra payments or borrowings.

(d) The interest rate on the HECS loan advantages rich domestic students because they are able to pay off their debt sooner and avoid paying as much HECS interest.

(e) The interest rate on the HECS loan advantages all domestic students because the alternative of borrowing from the bank to pay for education would usually attract a higher interest rate.

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:

(a) Inflation rate.

(b) Nominal GDP growth rate.

(c) Real GDP growth rate.

(d) Nominal total return on the share market index.

(e) Real total return on the share market index.

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'.

(a) ##r_\text{real} \approx r_\text{nominal} - r_\text{inflation}##

(b) ##(1+r_\text{real})^t = \left( \dfrac{1+r_\text{nominal}}{1+r_\text{inflation}} \right)^t ##

(c) ##V_\text{t,real} = V_\text{t,nominal}.(1+r_\text{inflation})^t##

(d) ##V_\text{0} = \dfrac{V_\text{t,nominal}}{(1+r_\text{nominal})^t}##

(e) ##V_\text{0} = \dfrac{V_\text{t,real}}{(1+r_\text{real})^t}##

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:

(a) Historical nominal total return was 10%.

(b) Historical real total return was 10%.

(c) Expected nominal total return was 10%.

(d) Historical nominal capital return was 10%.

(e) Expected real dividend return was 10%.

Question 114  WACC, capital structure, risk

A firm's WACC before tax would decrease due to:

(a) the firm's industry becoming more systematically risky, for example if it was a mining company and commodities prices varied more strongly and were more positively correlated with the market portfolio.

(b) the firm's industry becoming less systematically risky, for example if it was a child care centre and the government announced permanently higher subsidies for parents' child care expenses.

(c) the firm issuing more debt and using the proceeds to repurchase stock.

(d) the firm issuing more equity and using the proceeds to pay off debt holders.

(e) none of the above.

Question 115  capital structure, leverage, WACC

A firm has a debt-to-assets ratio of 50%. The firm then issues a large amount of debt to raise money for new projects of similar market risk to the company's existing projects. Assume a classical tax system. Which statement is correct?

(a) The debt-to-assets (D/V) ratio will decrease.

(b) The debt-to-equity ratio (D/E) will decrease.

(c) The firm's cost of equity will decrease.

(d) The company's after-tax WACC will decrease.

(e) The company's before-tax WACC will decrease.

Question 302  WACC, CAPM

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

(a) WACC before tax ##= r_D.\dfrac{D}{V_L} + r_{EL}.\dfrac{E_L}{V_L}##

(b) WACC before tax ##= r_f + \beta_{VL}.(r_m - r_f)##

(c) WACC after tax ##= r_D.(1-t_c).\dfrac{D}{V_L} + r_{EL}.\dfrac{E_L}{V_L}##

(d) WACC after tax ##= r_f + \beta_{VL}.(r_m - r_f) - \dfrac{r_D.D.t_c}{V_L}##

(e) WACC after tax ##= r_f + \beta_{VL}.(r_m - r_f)##

Question 936  CAPM, WACC, IRR

You work for XYZ company and you’ve been asked to evaluate a new project which has double the systematic risk of the company’s other projects.

You use the Capital Asset Pricing Model (CAPM) formula and input the treasury yield ##(r_f )##, market risk premium ##(r_m-r_f )## and the company’s asset beta risk factor ##(\beta_{XYZ} )## into the CAPM formula which outputs a return.

This return that you’ve just found is:

(a) The IRR of the company’s new project.

(b) The required return of the company’s new project.

(c) The IRR of the company’s assets.

(d) The required return of the company’s assets.

(e) The IRR of the company’s equity.

Question 3  DDM, income and capital returns

The following equation is called the Dividend Discount Model (DDM), Gordon Growth Model or the perpetuity with growth formula: ### P_0 = \frac{ C_1 }{ r - g } ###

What is ##g##? The value ##g## is the long term expected:

(a) Income return of the stock.

(b) Capital return of the stock.

(c) Total return of the stock.

(d) Dividend yield of the stock.

(e) Price-earnings ratio of the stock.

Question 18  DDM, income and capital returns

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_{\text{eff}} - g_{\text{eff}}} ###

What is the discount rate '## r_\text{eff} ##' in this equation?

(a) The expected total return of the stock.

(b) The expected capital return of the stock.

(c) The expected dividend return of the stock.

(d) The expected income return of the stock.

(e) The expected growth rate of the stock price.

Question 21  income and capital returns, bond pricing

A fixed coupon bond was bought for $90 and paid its annual coupon of $3 one year later (at t=1 year). Just after the coupon was paid, the bond price was $92 (at t=1 year). What was the total return, capital return and income return? Calculate your answers as effective annual rates.

The choices are given in the same order: ## r_\text{total},r_\text{capital},r_\text{income} ##.

(a) -0.0556, -0.0222, -0.0333

(b) 0.0222, -0.0111, 0.0333.

(c) 0.0333, 0.0556, 0.0222.

(d) 0.0556, 0.0222, 0.0333.

(e) 0.0556, 0.0333, 0.0222.

Question 28  DDM, income and capital returns

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_{\text{eff}} - g_{\text{eff}}} ###

What would you call the expression ## C_1/P_0 ##?

(a) The expected total return of the stock.

(b) The expected income return of the stock.

(c) The expected capital return of the stock.

(d) The expected growth rate of the dividend.

(e) The expected growth rate of the stock price.

Question 41  DDM, income and capital returns

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

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

Assume that the assumptions of the DDM hold and that the time period is measured in years.

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

(a) ## d_1(1+g)^3 ##

(b) ## P_3(r-g) ##

(c) ## d_2(1+g)^2 ##

(d) ## P_0(1+g)^3(r-g) ##

(e) ## P_0(1+g)^2(r-g) ##

Question 16  credit card, APR, effective rate

A credit card offers an interest rate of 18% pa, compounding monthly.

Find the effective monthly rate, effective annual rate and the effective daily rate. Assume that there are 365 days in a year.

All answers are given in the same order:

### r_\text{eff monthly} , r_\text{eff yearly} , r_\text{eff daily} ###

(a) 0.0072, 0.09, 0.0002.

(b) 0.0139, 0.18, 0.0005.

(c) 0.0139, 6.2876, 0.0055.

(d) 0.015, 0.1956, 0.0005.

(e) 0.015, 0.1956, 0.006.

Question 763  multi stage growth model, DDM

A stock is expected to pay its first dividend of $20 in 3 years (t=3), which it will continue to pay for the next nine years, so there will be ten $20 payments altogether with the last payment in year 12 (t=12).

From the thirteenth year onward, the dividend is expected to be 4% more than the previous year, forever. So the dividend in the thirteenth year (t=13) will be $20.80, then $21.632 in year 14, and so on forever. The required return of the stock is 10% pa. All rates are effective annual rates. Calculate the current (t=0) stock price.

(a) $202.7888

(b) $212.0218

(c) $233.35

(d) $448.2298

(e) $469.558

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.

(a) $71.2986

(b) $62.0921

(c) $61.5028

(d) $54.276

(e) $53.5612

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?

(a) The nominal cash flow of $100 in 5 years is equivalent to a real cash flow of $86.2609 in 5 years. This means that $86.2609 will buy the same amount of goods and services now as $100 will buy in 5 years.

(b) The real discount rate of 10% pa is equivalent to a nominal discount rate of 13.3333% pa.

(c) The nominal price of goods and services will increase by 3% every year.

(d) The real price of goods and services will increase by 3% every year.

(e) The present value of your payment will increase by the nominal discount rate every year.

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:

(a) Pay no income cash flow.

(b) Have a nominal total return of zero.

(c) Have a nominal capital return of zero.

(d) Have a nominal income return of zero.

(e) Have a real total return of zero.

Question 49  inflation, real and nominal returns and cash flows, APR, effective rate

In Australia, nominal yields on semi-annual coupon paying Government Bonds with 2 years until maturity are currently 2.83% pa.

The inflation rate is currently 2.2% pa, given as an APR compounding per quarter. The inflation rate is not expected to change over the next 2 years.

What is the real yield on these bonds, given as an APR compounding every 6 months?

(a) 0.3086%

(b) 0.6171%

(c) 0.6181%

(d) 0.6239%

(e) 0.6300%

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

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

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

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

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

(a) The nominal property price is expected to grow by approximately 9% pa.

(b) The nominal property price is expected to grow by approximately 5% pa.

(c) The nominal property price is expected to grow by approximately 4% pa.

(d) The real property price is expected to grow by approximately 7% pa.

(e) The real property price is expected to grow by approximately 6% pa.

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

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

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

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

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

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

(a) Today the price would have increased significantly.
Over the next 2 years, the bond price is expected to increase, measured on each ex-coupon date.

(b) Today the price would have increased significantly.
Over the next 2 years, the bond price is expected to be unchanged, measured on each ex-coupon date.

(c) Today the price would have been unchanged.
Over the next 2 years, the bond price is expected to increase, measured on each ex-coupon date.

(d) Today the price would have decreased significantly.
Over the next 2 years, the bond price is expected to increase, measured on each ex-coupon date.

(e) Today the price would have decreased significantly.
Over the next 2 years, the bond price is expected to be unchanged, measured on each ex-coupon date.

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.

(a) 11.100%, 4.000%, 7.100%.

(b) 11.140%, 4.040%, 7.100%.

(c) 4.902%, 0.000%, 4.902%.

(d) 9.140%, 4.040%, 5.100%.

(e) 9.140%, 4.040%, 7.100%.

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?

(a) ##C_\text{real, t}=C_\text{nominal,t}.(1+r_\text{inflation})^t##

(b) ##C_\text{real,t}=\dfrac{C_\text{nominal,t}}{(1+r_\text{inflation})^t} ##

(c) ##C_\text{real,t}=\dfrac{C_\text{nominal,t}}{r_\text{inflation}} ##

(d) ##C_\text{real,t}=C_\text{nominal,t}.r_\text{inflation} ##

(e) ##C_\text{real,t}=C_\text{nominal,t}.r_\text{inflation}.t##

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.

(a) Real house prices must grow by more than the maximum target inflation rate in perpetuity.

(b) Real house prices must grow by less than or equal to the maximum target inflation rate in perpetuity.

(c) Nominal house prices must grow by more than the maximum target inflation rate in perpetuity.

(d) Nominal house prices must grow by less than or equal to the maximum target inflation rate in perpetuity.

(e) Real house prices must grow by more than nominal house prices in perpetuity.

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.

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.

(a) $21,600,     $95,035.46

(b) $21,600,     $49,515.44

(c) $21,600,     $4,909.33

(d) $21,600,     $2,557.86

(e) $11,254.05,     $2,557.86

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) The firm's enterprise value is less than its total asset value.

(b) The firm's enterprise value beta is higher than the total asset value beta.

(c) The enterprise value's weighted average cost of capital (WACC) is higher than the total asset value's WACC.

(d) The enterprise value divided by the number of shares equals the share price.

(e) The total asset value less the market value of debt, all divided by the number of shares, equals the share price.

Question 512  capital budgeting, CFFA

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

Project Data
Project life	2 years
Initial investment in equipment	$6m
Depreciation of equipment per year for tax purposes	$1m
Unit sales per year	4m
Sale price per unit	$8
Variable cost per unit	$3
Fixed costs per year, paid at the end of each year	$1.5m
Tax rate	30%

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

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

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

(a) -6,   12.25,   16.68

(b) -6.8,   13.25,   14.05

(c) -6.8,   13.25,   15.88

(d) -6.8,   13.25,   18.51

(e) -6.8,   13.25,   17.71

Question 410  CAPM, capital budgeting

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) The current central bank policy rate (RBA overnight money market rate).

(b) The current 30 day federal government treasury bill rate.

(c) The average historical 30 day federal government treasury bill rate over the last 20 years.

(d) The current 30 year federal government treasury bond rate.

(e) The average historical 30 year federal government treasury bond rate over the last 20 years.

Question 409  NPV, capital structure, capital budgeting

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##

(a) ##ΔV=800m, ΔD = 600m, ΔE=200m##

(b) ##ΔV=200m, ΔD = 600m, ΔE= 0##

(c) ##ΔV=200m, ΔD =0m, \quad ΔE=200m##

(d) ##ΔV=400m, ΔD = 600m, ΔE=-200m##

(e) ##ΔV=800m, ΔD = 800m, ΔE= 0##

Question 345  capital budgeting, break even, NPV

Project Data
Project life	10 yrs
Initial investment in factory	$10m
Depreciation of factory per year	$1m
Expected scrap value of factory at end of project	$0
Sale price per unit	$10
Variable cost per unit	$6
Fixed costs per year, paid at the end of each year	$2m
Interest expense per year	0
Tax rate	30%
Cost of capital per annum	10%

Notes

1. The firm's current liabilities are forecast to stay at $0.5m. The firm's current assets (mostly inventory) is currently $1m, but is forecast to grow by $0.1m at the end of each year due to the project.
   At the end of the project, the current assets accumulated due to the project can be sold for the same price that they were bought.
2. A marketing survey was used to forecast sales. It cost $1.4m which was just paid. The cost has been capitalised by the accountants and is tax-deductible over the life of the project, regardless of whether the project goes ahead or not. This amortisation expense is not included in the depreciation expense listed in the table above.

Assumptions

• 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 3% pa.
• All rates are given as effective annual rates.

Find the break even unit production (Q) per year to achieve a zero Net Income (NI) and Net Present Value (NPV), respectively. The answers below are listed in the same order.

(a) 750,000 and 750,000.

(b) 750,000 and 951,682.

(c) 750,000 and 987,396.

(d) 750,000 and 1,009,805.

(e) 750,000 and 1,024,807.

Question 989  PE ratio, Multiples valuation, leverage, accounting ratio

A firm has 20 million stocks, earnings (or net income) of $100 million per annum and a 60% debt-to-equity ratio where both the debt and asset values are market values rather than book values. Similar firms have a PE ratio of 12.

Which of the below statements is NOT correct based on a PE multiples valuation?

(a) The EPS is $5.

(b) The market capitalisation of equity is $1.2 billion.

(c) The share price is $60.

(d) The market capitalisation of debt is $0.72 billion.

(e) The debt-to-assets ratio is 40%.

Question 131  APR, effective rate

Calculate the effective annual rates of the following three APR's:

• A credit card offering an interest rate of 18% pa, compounding monthly.
• A bond offering a yield of 6% pa, compounding semi-annually.
• An annual dividend-paying stock offering a return of 10% pa compounding annually.

All answers are given in the same order:

##r_\text{credit card, eff yrly}##, ##r_\text{bond, eff yrly}##, ##r_\text{stock, eff yrly}##

(a) 0.1956, 0.0609, 0.1.

(b) 0.015, 0.09, 0.1.

(c) 0.1881, 0.0609, 0.1025.

(d) 0.1956, 0.0617, 0.1047.

(e) 6.2876, 0.1236, 0.1.

Question 669  beta, CAPM, risk

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.

(a) ##Β_E=\dfrac{cov(r_E,r_M )}{var(r_M)}##

(b) ##Β_E=\dfrac{correl(r_E,r_M ).sd(r_E)}{sd(r_M)} ##

(c) ##Β_E=\dfrac{sd(r_E)}{sd(r_M)}##,   since ##var(r_E)=β_E^2.var(r_M)##

(d) ##Β_E=\dfrac{r_E-r_f}{r_M-r_f }##,   since ##r_E=r_f+Β_E. (r_M-r_f )##

(e) ##Β_E= \left(B_V - \dfrac{D}{V}.Β_D \right).\dfrac{V}{E}##,   since ##B_V=\dfrac{E}{V}.Β_E+\dfrac{D}{V}.Β_D ##

Question 165  DDM, PE ratio, payout ratio

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

Use the general accounting definition of 'payout ratio' which is dividends per share (DPS) divided by earnings per share (EPS) and assume that all cash flows, earnings and rates are real rather than nominal.

A company's forward-looking PE ratio will be the inverse of its total expected return on equity when it has a:

(a) 100% payout ratio and high expected growth in earnings and dividends.

(b) 100% payout ratio and negative expected growth in earnings and dividends.

(c) 100% payout ratio and no expected growth in earnings or dividends.

(d) 0% payout ratio and no expected growth in earnings or dividends.

(e) 0% payout ratio and negative expected growth in earnings and dividends.

Question 402  PE ratio, no explanation

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

(a) A company with positive earnings that does not have any comparable firms.

(b) A company with positive earnings that has comparable firms with positive earnings.

(c) A company with positive earnings that has comparable firms with negative earnings.

(d) A company with negative earnings that has comparable firms with negative earnings.

(e) A company with negative earnings that has comparable firms with positive earnings.

Question 403  PE ratio, no explanation

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

(a) Common equity in a small private company.

(b) Common equity in a listed public company.

(c) Commercial real estate.

(d) Ten year commercial real estate lease.

(e) Residential real estate.

Question 468  PE ratio

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?

(a) 20

(b) 10

(c) 3

(d) 2

(e) 0.5

Question 474  PE 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 backwards-looking price-earnings ratio?

(a)17.06

(b) 0.063

(c) 15.88

(d) 3.21

(e) 8.44

Question 493  PE ratio

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

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

(a) 2.5

(b) 3

(c) 6

(d) 15

(e) 20

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:

(a) Earnings per share (EPS) is $3.60.

(b) Dividend per share is $1.68.

(c) Payout ratio is 53.27%.

(d) The market value of equity is $774.39 billion.

(e) Number of shares outstanding is 7.68 billion.

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. No new equity or debt will be issued to fund the new projects, they'll all be funded by the cut in dividends.

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 (so there's no signalling effects) and that all rates are effective annual rates.

(a) 2.7% pa.

(b) 3.0% pa.

(c) 3.5% pa.

(d) 3.3% pa.

(e) 3.8% pa.

Question 132  bill pricing, simple interest rate

A 90-day Bank Accepted Bill (BAB) has a face value of $1,000,000. The simple interest rate is 10% pa and there are 365 days in the year. What is its price now?

(a) $10,000,000.00

(b) $8,021,978.02

(c) $976,772.86

(d) $975,935.83

(e) $100,000.00