Fundamentals of Business Finance Solution to mid-semester exam autumn semester 2011

PART A: MULTIPLE CHOICE QUESTIONS (15 MARKS)

1. The most important function of a financial market is: a) to facilitate the flow of funds between lenders and borrowers b) to provide a market for shares so there are always buyers c) to provide information about an issuing companys financial situation d) to secure profits for brokers and agents e) to provide information about shares Ans: A Which one of the following statements is related to capital budgeting decision? A firm should monitor the ratio of debt to equity financing which it uses. A firm should monitor the amount of its current assets as compared to its current liabilities. A firm should consider the size, risk, and timing of a proposed assets cash flows before deciding to purchase that asset. d) A firm should consider various types of loans offered by various lenders before taking out a loan. e) A firm should determine the ideal level of inventory that should be kept on hand. Ans: C 3. a) b) c) d) e) In a general partnership, each partner is personally liable for: the partnership debts that he or she created his or her proportionate share of all partnership debts regardless of which partner incurred that debt the total debts of the partnership, even if he or she was unaware of those debts the debts of the partnership up to the amount he or she invested in the partnership all personal and partnership debts incurred by any partner, even if he or she was unaware of those debts 2. a) b) c)

Ans: C 4. Today, Courtney wants to invest less than $5,000 with the goal of receiving $5,000 back some time in the future. Which one of the following statements is correct? a) The period of time she has to wait until she reaches her goal is unaffected by the compounding of interest. b) The lower the rate of interest she earns, the shorter the time she will have to wait to reach her goal. c) She will have to wait longer if she earns 6 per cent compound interest instead of 6 per cent simple interest. d) The length of time she has to wait to reach her goal is directly related to the interest rate e) The period of time she has to wait decreases as the amount she invests today increases. Ans: E 5. You have just won a lottery, which offers a choice in how you may receive your prize. If the interest rate is 10% per annum, compounded annually, which of the following prizes has the highest present value? a) $2,000,000 immediately b) an ordinary annuity of $300,000 per year for each of the next 10 years (starting one year from now) c) $3,000,000 at the end of five years d) $3,500,000 at the end of nine years e) a perpetuity of $250,000 per year starting one year from now Ans: E

6. The Effective Annual Interest Rate (EAR) is defined as the interest rate that is: a) compounded at regular intervals throughout the year b) equal to a monthly rate multiplied by twelve c) computed by multiplying the rate per period by the number of compound periods per year d) expressed as if it were compounded once per year e) compounded only once over a multi-year period Ans: D 7. Jodie's Fashions has just signed a $2.2 million contract. The contract calls for a payment of $600,000 today, $800,000 one year from today, and $800,000 two years from today. What is this contract worth today if the firm can earn 7.2 per cent on its money? a) $2 038 616.67 b) $2 042 414.79 c) $2 108 001.32 d) $2 124 339.07 e) $2 202 840.91 Ans: B 8. The general purpose of protective covenants is to help protect: a) the company, in the case of rising interest rates b) the company, in the case of rapid growth c) the lenders, from company actions contrary to the lenders benefit d) the lenders, from early calls of their bonds e) the lenders, from increased equity in the firm Ans: C 9. When you refer to a bond's coupon, you are referring to which one of the following? a) difference between the purchase price and the face value b) annual interest divided by the current bond price c) difference between the bid and the ask price d) annual interest payment e) principal amount of the bond Ans: D 10. You are going to receive ten payments of $100 per year. You will receive the first payment today. What is the present value of this payment stream if money is worth 8%pa to you? a) $533.49 b) $586.84 c) $724.69 d) $771.01 e) $1,000.00 Ans: C 11. Tellite Ltd, a telecommunication company, did not pay a dividend in the last financial year. However, the company has indicated that it expects to earn $1 per share in this financial year and to pay out $0.20 of these earnings in dividends. Financial analysts expect that Tellites earnings per share and dividend per share will grow at a rate of 10% a year. The rate of return required by investors has been estimated at 12% per annum. Estimate the current day value of the share. a) $10.00 b) $50.00 c) $11.00 d) $5.50 e) $5.00 Ans: A 2

12. What is true about a preference share? a) The preference share is a form of equity from a legal standpoint. b) The preference share may have preference over ordinary shares in the payment of dividends. c) Holders of the preference shares usually have no voting rights. d) Unpaid preference share dividends are not debts of the company. e) All of the given answers are true. Ans: E 13. The current price of a share is based: a) primarily on the future value of the cash flows derived from the share b) on the anticipated future dividends for the next ten years c) on the present value of all the future cash flows forecast from holding that share d) strictly on the anticipated future share price e) on the present value of the dividends and the repayment of the principal Ans: C 14. Which one of the following statements is correct concerning the payback rule? a) The payback period is computed using the present value of each of the cash flows. b) The rule says that you should accept a project if the payback period is greater than one. c) The rule works best when comparing mutually exclusive projects. d) The rule is biased in favour of long-term projects. e) The rule is flawed because it ignores all cash flows after some arbitrary point in time. Ans: E 15. You are using a net present value profile to compare investments A and B, which are mutually exclusive. Which one of the following statements correctly applies to the crossover point between these two? a) The internal rate of return for project A equals that of project B, but generally does not equal zero. b) The internal rate of return of each project is equal to zero. c) The net present value of each project is equal to zero. d) The net present value of project A equals that of project B, but generally does not equal zero. e) The net present value of each project is equal to the respective project's initial cost. Ans: D

PART B: SHORT ANSWER QUESTIONS (15 MARKS)

Question 1 (3 marks) Royal Communications is considering investing in a new updated computer system. Royal Communications uses a discount rate of 12.5% and sometimes uses the profitability ratio or benefits to cost ratio that it is sometimes called. Royal Communications has narrowed its choice down to two options: Big Blue and Pears, the cash flows for each option appear in the following table: Year 0 Year 1 Year 2 Year 3 Big Blue -6,000 3,500 3,500 2,000 Pears -7,000 1,000 1,000 8,000 a) Which option would be accepted using the NPV rule? (2 marks)

NPVBig Blue = -6,000 + 3,500(1.125)-1 + 3,500(1.125)-2 + 2,000(1.125)-3 = -6,000+ 3,111.11+2,765.43+1,404.66 = 1,281.20 Fin Cal steps [FV=3,500; i=12.5; n =1; PMT=0; PV = ?] [FV=3,500; i=12.5; n =2; PMT=0; PV = ?] [FV=2,000; i=12.5; n =3; PMT=0; PV = ?]

NPVpears =-7,000 + 1,000(1.125)-1 + 1,000(1.1225)-2 + 8,000(1.125)-3 = -7,000 + 888.89+790.12+5,618.66 = 297.67 Fin Cal steps [FV=1,000; i=12.5; n =1 PV = ?] [FV=1,000; i=12.5; n =2 PV = ?] [FV=8,000; i=12.5; n =3 PV = ?] Accept Big Blue
b) What is each options profitability index number? (1 mark)

Take the NPV in a) and add back the investment and divide by the investment PIBig Blue = (1,281.20+6,000) /6,000 = 1.214 PIpears = (297.67+7,000) /7,000 = 1.0425
Question 2 (3 marks) On April 1st 2005 Gumtree productions issued a bonds with a maturity date of 1st April 2015. The bonds face value is $230,000 and the coupon rate is 5.75% p.a. paid half-yearly. Gumtree bonds current YTM is 9.5% p.a. a) What is the current bond price if today is 1st April 2011? (2 Marks)

Coupon payments are twice a year Coupon amount = 230,000 x 5.75% 2 = 6,612.50 Market yield is 9.5% therefore i= 4.75% Years to maturity: today is 1 st April 2011: maturity date is 1 st April 2015 thus 4 years remaining therefore n= 8
Apr/ Apr/ 11 12 13 14 15  0 1 2 3 4 5 6 7 8

Calculations Formula PV = 6,612.50 (1-(1.0475)-8)/0.0475 +230,000 (1.0475)-8 =201,843.53

Calculations Fin Calculator FV= 230,000 PMT= 6,612.50 i=4.75; n =8 PV = ? 201,843.53

b) Give an example of a covenant that may be contained in a Trust Deed (1 Mark)

One mark for any reasonable suggestion -some examples from the text book Negative covenants y The firm must limit the amount of dividends it pays according to some formula. y The firm cannot pledge any assets to other lenders. y The firm cannot merge with another firm. y The firm cannot sell or lease any major assets without approval by the lender. y The firm cannot issue additional long-term debt. Positive covenants y The company must maintain its working capital at or above some specified minimum level. y The company must periodically furnish audited financial statements to the lender/trustee. y The firm must maintain any collateral or security in good condition.
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Question 3 (3 marks) As an astute share investor you want to perform a valuation of Rabbit Fences Limited to determine if you want to buy shares in its new issue. Rabbit Fences Limited is about to list on the Australian Securities Exchange. Rabbit Fences prospectus forecasts no dividends for three years. Its dividend payment in year four will be $0.35 and the flowing year $0.55. From year 6 the dividend will increase at a constant 3.5% annual rate. If the required return for Rabbit Fences is 13.75%, what is the maximum price you would be prepared to pay for one Rabbit Fences Limited share?
0 1 2 3 4 5 6 - D4=$0.35 D5=$0.55 =>3.5%

Required return is = 13.75% PV the dividends and the constant growth back today Value of constant growth in dividends at end of year 5 P5 = $0.55(1.035) / (0.1375 - 0.035) = 5.5537 or at end of year 6 P4 = D5/(r - g) = $0.55 / (0.1375- 0.035) = 5.3659 Calculations Formula PV4 = 0.35(1.1375)-4 = 0.2091 PV 5 = 0.55(1.1375)-5 =0.2888 PV 5 = 5.5537(1.14)-5 =2.9163 Calculations Fin Calculator FV=0.35; i=13.75; n =4 PV = ? FV=0.55; i=13.75; n =5 PV = ? FV=5.5537; i=13.75; n =5 PV =

Price today = 0.2091+0.2888+2.9163 = 3.4142 Or if used dividend from year5 Price today = 0.2091 + 5.3659(1.1375)-4 = 0.2091 + 3.2051 = 3.4142
Question 4 (2 marks) Outback Stores requires approximately $300,000 to finance new inventory required for the winter season. Outback has a 180 day bank bill facility with Western Bank. Outback stores will draw up a 180day bank bill that will be accepted by Western Bank. a) If the current 180day bank bill rate is 7.25% today, what amount will Outback stores receive today? (1 mark)

Price = 300,000/( 1 + 0.0725 x 180/365) = 300,000/(1.03575342) = 289,644.23

b) If Outback Stores sells all its inventory after 120 days and wants to buy back the bill at the current market rate of 6.96% for bills of this type. What is the price Outback must pay to buy the bill? (1 mark)

Now only 60 days to maturity (180-120) Price = 300,000/( 1 + 0.0696 x 60/365) = 300,000/(1.011441096) = 296,606.50

Question 5 (4 marks) Olga Developments Limited wants to invest in a new item of plant. The new plant will cost $230,000 with two instalments being paid. One today of $200,000 and one in two years time of $30,000. Olga believes that once the plant is operational that it will produce cash inflows of $36,000 in year 4, $48,000 in year 5, 6 and 7 then $50,000 for the next five years. If the cost of financing this plant is 12% should Olga Developments Limited buy the plant? (show all workings to prove your answer)
0 1 2 3 4 5 6 7 8 9 10 11 12 --- -200 -30 36 48 48 48 50 50 50 50 50

Need to present value the cash flows (you could work out the future values) There are a numbers of ways to work this out

Calculations Formula PV = -30,000(1.12)-2 = -23,915.82 PV = 36,000(1.12)-4 = 22,878.65

Calculate PV value of 3 PMTs @ 48,000 PV annuity problem PV = 48,000(1- (1.12)-3/0.12 PV = 115,287.90 (this is the PV at period 4) PV = 115,287.90 (1.12)-4 = 73,267.55 Calculate PV value of 5 PMTs @ 50,000 PV annuity problem PV = 50,000(1- (1.12)-5/0.12 :PV = 180,238.81 (this is the PV at period 7) PV = 180,238.81 (1.12)-7 PV = 81,530.88

Calculations Fin Calculator FV = -30,000 i = 12 N = 2 PV =? = -23,915.82 FV = 36,000 i = 12 N = 2 PV =? = 22,878.65 PMT = 48,000.00 i = 12 n= 3 (FV=0) PV= 115,287.90 FV = 115,287.90i = 12 N = 4 PV =? = 73,267.55 PMT = 50,000.00 i = 12 n= 5 (FV=0) PV= 180,238.81 FV = 180,238.81 i = 12 N = 7 PV =? = 81,530.88

Net value today -200,000.00 - 23,915.82 + 22,878.65 +73,267.55+ 81,530.88 =-46,238.74 Do not buy plant FV = PV (1 + i)-n
Period 0 2 4 5 6 7 8 9 10 11 12 Cash flow Present Value -200,000 -200,000.00 -30,000 -23,915.82 36,000 22,878.65 48,000 27,236.49 48,000 24,318.29 48,000 21,712.76 50,000 20,194.16 50,000 18,030.50 50,000 16,098.66 50,000 14,373.81 50,000 12,833.75 6