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  • 1. Name (Please Print):     Key SSN (Last 4 digits):  0000       MBA643.001  Managerial Finance  School of Management, GMU Spring 2004 Final Exam (Total 100 points) Please answer all problems. Show all work in the blank spaces provided following the questions. Do not use the back pages for any purpose. Any writing on the back pages will NOT be graded. Be careful to avoid arithmetic mistakes. Check your answers. This is a closed-book, closed-note exam. You also need to turn in the formula sheet. After you finish, sign the pledge below. HONORABLE CONDUCT In academic work is the spirit of conduct in this university In recognition of and in the spirit of the Honor Code, I certify that I have neither given nor received aid on this examination and that I will report all Honor Code violations observed by me. Note: It is an honor code violation to discuss this exam with students in the other section if this class has multiple sections. (Signed) _____________________________________________ PAGE 1
  • 2. Part A: Choose the correct answer (Total 50 points: Q1~10: 3 points each, Q11~15: 4 points each) 1 Which of the following amounts is closest to the net present value of a project that contributes $5,000 at the end of the first year and $8,000 at the end of the second year. The initial cost is $3,000. The appropriate interest rate is 8% for the first year and 10% for the second year. (A) $8,585 (B) $8,426 (C) $8,363 (D) $8,073 2 Which of the following statements is most correct? (A) Actions that increase net income will always increase net cash flow. (B) One way to decrease EVA is to maintain the same operating income with less capital. (C) The use of debt in a company’s capital structure results in tax benefits to the investors who purchase the company’s stock. (D) A firm with financial leverage has a smaller equity multiplier than an otherwise identical firm with no debt in its capital structure. 3 Which of the following statements is true? (A) The security market line plots the historic relationship between returns on an individual stock and the market risk premium. (B) For mutually exclusive projects, the project with the highest NPV is always the correct selection regardless of IRR. (C) An annuity factor represents the present value of $1 that is deposited today. (D) (B) and (C) are correct. 4 How much should you pay for a share of stock that offers a constant growth rate of 10%, requires a 16% rate of return, and is expected to sell for $50 two years from now? (A) $41.32 (B) $43.40 (C) $45.45 (D) $47.57 5 Which of the following statements is true? (A) When a security is added to a portfolio, the appropriate return is the beta times the market risk premium. (B) When a security is added to a portfolio, the appropriate risk contribution is the standard deviation of the asset. (C) Once a portfolio is diversified, the type of risk remaining is the risk from risk- free rates. (D) Once a portfolio is diversified, the type of risk remaining is the risk related to the market portfolio. CCDAD PAGE 2
  • 3. 6 The reason that M/M Proposition I does not hold in the presence of corporate taxation is because: (A) Levered firms pay less tax compared with identical unlevered firms. (B) Bondholders require higher rates of return compared with stockholders. (C) Earnings per share are no longer relevant with taxes. (D) Dividends are no longer relevant with taxes. 7 Which of the following is not one of the potential conflicts between stockholders and bondholders? (A) Differential risk exposure. (B) Dividend payouts. (C) Underinvestiments. (D) Asset substitution. 8 The stock price of a firm under M/M Proposition I & II without taxes is: (A) Invariant to the level of debt because the number of shares is reduced. (B) The expected return to equity holders rises as debt increases offsetting the leverage advantage. (C) The value of the firm is constant with equity or debt financing. (D) All of the above. 9 AT&B has a debt-to-equity ratio of 2.5. Its rWACC is 15%, and its cost of debt is 11%. The corporate tax rate is 35%. What would the weighted average cost of capital be if the debt-to-equity ratio is 0.8? (A) 15.00% (B) 11.85% (C) 12.67% (D) 12.75% 10 One of the indirect costs of bankruptcy is the incentive for managers to take large risks. When following this strategy, the firm will: (A) Rank all projects and take the project which results in the highest expected value of the firm. (B) Rank all projects and take the project which results in the highest expected value of the firm’s bonds. (C) Rank all projects and take the project which results in the highest expected value of the firm’s stock. (D) Always take the low risk project. AADCC PAGE 3
  • 4. 11 Portfolio P has 30% invested in Stock X and the remaining in Stock Y. The risk-free rate is 6% and the market risk premium is 5%. Portfolio P has a required rate of return of 11.3% and Stock X has a beta of 0.75. What is the beta of Stock Y? (A) 0.95 (B) 1.19 (C) 1.39 (D) 1.64 12 If the weak form of efficient markets holds, then: (A) Technical analysis is useless. (B) Stock prices reflect all public information. (C) The prices follow a random walk. (D) Statements (A) and (B) are correct. 13 The abnormal return on a security for a particular day can be estimated by the equation: (A) ARi = Rf - RM (B) ARi = Ri - RM (C) ARi = Ri - Rf (D) ARi = Rf - Ri 14 Is this statement true? A risky security cannot have an expected return that is less than the risk-free rate because no risk-averse investor would be willing to hold this asset in equilibrium. (A) False, because investors can buy this security to reduce the variance of their portfolios. (B) True, because investors require higher returns than the risk-free rate when they buy risky securities. (C) False, because investors can buy this security to increase the returns of their portfolios. (D) True, because risk-averse investors require higher returns than the risk-free rate. 15 Which of the following statements is not true? If a portfolio has a positive weight for each asset, (A) The expected return on the portfolio can not be greater than the return on the asset in the portfolio that has the highest return. (B) The expected return on the portfolio can not be less than the return on the asset in the portfolio that has the lowest return. (C) The expected return on the portfolio is simply the summation of individual weights times the expected returns of the assets. (D) The expected return on the portfolio equals the average of the highest return and the lowest return. BABAD PAGE 4
  • 5. Part B: Points are indicated in each question. Please show all your work. Question 1: Define or Comment briefly (12 points) (a). Premium in takeovers Premium in takeovers is defined as the offer price minus the pre-announcement market price. (b). If the market is efficient, stock prices should only be expected to react to new information that is released. This statement is true. Under EMH, markets can not predict the future. All of the prices only reflect the information that is released. PAGE 5
  • 6. Question 2 (18 points) (a). Suppose a Miller equilibrium exists (VL = VU) with corporate tax rate of 30% and personal tax rate on income from bonds of 35%. What is the personal tax rate on income from stocks? 0 = 1-(1-0.3)(1-TS)/(1-0.35) => TS = 0.071 = 7.1% (b). The Zercon Company has EBIT of $50,000 and market value debt of $100,000 outstanding with a 9% coupon rate. The cost of equity for an all equity firm would be 14%. Zercon has a 35% corporate tax rate. Investors face a 20% tax rate on debt receipts and a 15% rate on equity. (b1). What is the value of Zercon if the firm is unlevered? VU = 50,000*(1-0.35)/0.14 = 232,142.86 (b2). What is the current value of Zercon? VL = 232,142.86 + 100,000*[1-(1-0.35)(1-0.15)/(1-0.2)] = 263,080.36 PAGE 6
  • 7. Question 3 (20 points) Assume the CAPM is the model of market equilibrium. The risk-free rate is 3 percent. The expected market risk premium is 7 percent. You, as a consultant for not-for-profit organizations, are working on a fund raising project called “Save for Africa”. You plan to raise a certain amount of funds at the end of each year for the next 4 years (year 1 to 4) and save the funds into the Green Bio Mutual Fund with a beta of 0.8. At the end of the fourth year, you will deposit the money into a savings account that earns 3.0 percent annually. You will start your project in Africa in year 7 and expect to complete it in 5 years. To meet your goal, you have to withdraw a constant amount of $250,000 from this account for five years. Assume that the expected return on the mutual fund will be the same each year for the next four years after you make the first deposit to the mutual fund. Given your investment strategy, answer the following questions: (a). What is the expected return on your Green Bio Mutual Fund? r = 0.03 + 0.8*0.07 = 0.086 (b). How much will you need to deposit in the Green Bio Mutual Fund each year?  1 1   1 1  1 D − 4  * (1.086) 4 = 250,000 − 5  * 2  0.086 (0.086)(1.086)   0.03 (0.03)(1.03)  1.03 => D = 237,385.80 PAGE 7