Reference no: EM132004525

Part -1:

Section A

Each of these ten multiple-choice questions is worth one mark. Circle the letter corresponding to the one alternative that best completes the statement or answers the question. Each question is worth one mark.

1. Suppose that your company is expected to pay a dividend of $1.70/share next year. There has been a steady growth in dividends of 5.1%/year and the market expects that to continue. The current price is $35. What is the cost of equity?
a) 0.100
b) 0.200
c) 0.015
d) 0.001

2. Which one of the following is best classified as unsystematic risk?
a) An unexpected recessionary period
b) An unexpected increase in interest rates
c) An unexpected decline in the sales of a firm
d) A sudden increase in the inflation rate

3. The goal of diversification is to eliminate:
a) Total risk.
b) The market risk premium.
c) Systematic risk.
d) Unsystematic risk.

4. Which one of the following has a rate of return that is used as a proxy for the risk-free rate?
a) Treasury notes (short-term government securities)
b) Large-company stocks
c) Long-term corporate bonds
d) Inflation, as measured by the consumer price index

5. A risk premium is defined as:
a) The expected market return
b) The premium you have to pay for investing in risky assets
c) The premium you have to pay for investing in assets that have high returns with low risk.
d) The extra return received on an asset above the risk free rate

6. What is the Beta of the market?
a) 0
b) 1
c) 2
d) Depends on the systematic risk in the market risk in the market

7. The cost of capital for a project should:
a) Be adjusted based on the size of the project
b) Remain constant even if a decision on accepting the project is delayed for two years.
c) Be adjusted based on the risk of the project
d) Meet or exceed the internal rate of return of the project

8. When the management of the firm evaluates the risk of a proposed project and adjusts the firm's WACC based on that evaluation to ascertain the required return for the project, they are using the _ approach:
a) Subjective
b) Pure play
c) Insider
d) Normative

9. If you invest $5000 now, and your investment pays 12% per annum, how much will you have in three years if compounded quarterly?
a) $7128.80 b) $7218.80 c) $7812.80 d) $7182.80

10. Suppose your company has an equity beta of 0.58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?
a) 13.11%.
b) 10.11%
c) 12.32%.
d) 11.09%.

Section B:

QUESTION B1
The following two projects of equal risk are mutually exclusive alternatives for expanding the firm's capacity. The firm's cost of capital is 15%. The cash flows for each project are given in the following table.

	PROJECT A	PROJECT B
Initial investment	$60,000	$60,000
Year	Net cash inflows	Net cash inflows
1	$36,000	$46,500
2	$31,500	$30,000
3	$28,500	$15,000

Required:

a) Calculate each project's payback period. Using the payback period criterion which project is preferable?

b) Calculate the net present value for each project. Using the net present value criterion, which project is preferable?

c) Calculate the internal rate of return for each project. Using the internal rate of return criterion, which project is preferable?
(Calculate to the nearest percentage).

d) Calculate the profitability index. Using the profitability index criterion which project is acceptable?

e) Discuss any conflict in ranking that may exist between the four methods used and why the NPV is the best method.

QUESTION B2

Wombat productions will pay a dividend an annual dividend of $4 next year. Using regression analysis, you find that the company has maintained a constant dividend growth rate of 5% a year and you believe this will continue indefinitely.

Required:
a) If your required return on these shares is 15%, how much would you be willing to pay for each Wombat share?

b) If your required return on these shares is 10%, how much would you be willing to pay for each Wombat share?

c) What does your answers to parts (a) and (b) tell us about the relationship between the required return and the share price?

d) A number of listed companies do not pay dividends, but investors are still willing to buy shares in them. How is this possible?

QUESTION B3

Pacific Blue Limited has a beta of 0.8, the rate on Australian Treasury Bonds is 2.5% and the expected return for the All Ordinaries Index is 6%.

Required:
a) Calculate the required return (i.e. Expected Return) for Pacific Blue Limited.

b) What does it mean in terms of the market security line when 0 < beta < 1.00?

c) What does a beta coefficient measure? Define beta.

QUESTION B4

Woods Ltd has on its books the following amounts and after-tax cost for each source of capital:

Condition	Probability	Company A	Company B
Boom	0.15	21%	10%
Normal	0.75	12%	7%
Recession	0.10	3%	8%

Required:

a) Calculate the firm's weighted average cost of capital (WACC) using book value weights.

b) What is the cost of capital? What role does it play in making long-term investment decisions?

c) Explain why the cost of equity is higher than long-term borrowing?

d) What is the fundamental motivation behind portfolio theory? That is, what are people trying to achieve by investing in portfolios of securities rather than in a few individual shares or debentures?

Part -2

Section A: Multiple Choice Questions

Write in the answer booklet the letter corresponds to the one alternative that best completes the statement or answers the question. Each question is worth one mark.

1. Suppose that your company is expected to pay a dividend of $1.70/share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $35. What is the cost of equity?

a) 0.099
b) 0.200
c) 0.051
d) 0.102

2. Which one of the following is best classified as unsystematic risk?

a) An unexpected recessionary period
b) An unexpected increase in interest rates
c) Labour Strike
d) A sudden increase in the inflation rate

3. The goal of diversification is to eliminate:

a) Total risk
b) The market risk premium
c) Systematic risk
d) Unsystematic risk

4. A risk premium is defined as:

a) The expected market return
b) The premium you have to pay for investing in risky assets
c) The premium you have to pay for investing in assets that have high returns with low risk.
d) The extra return received on an asset above the risk free rate

5. What is the Beta of the market?

a) 0
b) 1
c) 2
d) Depends on the systematic risk in the market risk in the market

6. When a financial market reflects all the available information in the prices of the securities, the market is referred to as:

a) Primary market
b) Secondary market
c) Efficient capital market
d) Traditional market

7. A premium bond is a bond that:

a) Has a market price less than its par value
b) Has a market price equal to its par value
c) Has a market price which exceeds its par value
d) Has a market price determined by the investment banks

8. If you invest $5,000 now, and your investment pays 12% per annum, how much will you have in three years if compounded quarterly?

a) $7,128.80 b) $7,218.80 c) $7,812.80 d) $7,182.80

9. Suppose your company has an equity beta of 0.58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?

a) 13.11%.
b) 10.11%
c) 12.32%.
d) 11.09%.

10. Security Market Line (SML) is trying to display the relationship between:

a) Systematic risk and unsystematic risk
b) Risk and return
c) Assets and liabilities
d) Equities and liabilities

Section B: Long Answer Questions

Question 1

The following two projects of equal risk are mutually exclusive alternatives for expanding the firm's capacity. The firm's cost of capital is 12%. The cash flows for each project are given in the following table.

	PROJECT A	PROJECT B
Initial investment	$60,000	$60,000
Year	Net cash inflows	Net cash inflows
1	$36,000	$46,500
2	$31,500	$30,000
3	$28,500	$15,000

Required:
a) Calculate each project's payback period. Using the payback period criterion which project is preferable?
b) Calculate the net present value (NPV) for each project. Using the NPV, which project is preferable?
c) Calculate the profitability index. Using the profitability index criterion which project is acceptable?

Question 2

Sony Picture will pay an annual dividend of $4 next year. Using regression analysis, you find that the company has maintained a constant dividend growth rate of 5% a year.

Required:
a) If your required return on these shares is 15%, how much would you be willing to pay for each Sony Picture share?
b) If your required return on these shares is 10%, how much would you be willing to pay for each Sony Picture share?
c) What does your answers to parts (a) and (b) tell us about the relationship between the required return and the share price?

Question 3

BHP Ltd has a beta of 0.765, if the expected return of the market is 11.5% and the risk-free rate is 7.5%.

Required:
a) What is the appropriate required return of BHP Ltd?
b) What does a beta coefficient measure? Define beta.
c) What is the fundamental motivation behind portfolio theory? That is, what are people trying to achieve by investing in portfolios of securities rather than in a few individual shares or debentures?

Question 4
Jim Roger is considering a small portfolio of two stocks and has provided you with the following information:

Condition	Probability	Company A	Company B
Boom	0.15	21%	10%
Normal	0.75	12%	7%
Recession	0.10	3%	8%

Required:

What are the expected return and standard deviation for the portfolio with an investment of $10,000 (Company A) and $10,000 (Company B)?

Question 5

Fortescue Ltd is offering bonds with a coupon rate of 8% p.a., paid semi-annually. The par value of each bond is $1,000 and has eight (8) years to maturity. The yield to maturity is 9%. What is the value of the bond?