Business Finance Test Structure

• When, where, how long and structure:

See my message in Stream.

You should also see information under “How is this course assessed?” in the

125.230 Business Finance Course Guide. This is available electronically on the Stream site.

Business Finance Test Review

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Business Finance Test Material Foundation Material

Topics Covered in Test Textbook Learning Mastery • The Chapter 1 introductory and foundation material includes key finance
Chapters Outcomes Quiz concepts such as shareholder wealth maximisation. For this material you
should use Quiz 1 to help direct what areas (if any) you need to target for
Module 1.1 Core Concepts 1 LO1, LO3 Quiz 1 further study.
• Note: while ethics was discussed in Week 1 it will NOT be assessed in the
Module 1.2 Risk & Return 8 LO3, LO4 Business Finance Test.

Module 1.3 Interest Rates & Bond 6 LO3, LO4 Quiz 2

Module 1.4 Share Valuation 7
Module 2.1 Cost of Capital 9

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Valuation Fundamentals Chapters 8,6,7 & 9 Chapter 8: Risk & Return

• These chapters should be studied together as they are all based around • Sources and types of risk
valuation fundamentals. The formulas found in Chapters 8 (CAPM), 6 • Calculation of expected return, standard deviation
(approximate YTM) and 7 (equity valuation formulas) are used again in • Impact of diversification: by adding assets to a portfolio that are not
Chapter 9. perfectly positively correlated, the overall portfolio risk will reduce.

• CAPM formula rj = RF + β(rm – RF)

Risk free rate Risk premium for assetj

• Remember the difference between market return (rm) and market risk
premium (rm ‐ RF).

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 Concept Review Questions Concept Review Questions
1. Brooklyn has a beta of 0.7. The risk free rate is 6 per cent and the expected 1. Brooklyn has a beta of 0.7. The risk free rate is 6 per cent and the expected
market return is 12 per cent. What is Brooklyn’s required return? market return is 12 per cent. What is Brooklyn’s required return?
r = .06 + 0.7(.12 ‐ .06)
r = .102 or 10.2%
r = .102 or 10.2%
2. Brooklyn has a beta of 0.7. The risk free rate is 6 per cent and the expected
2. Brooklyn has a beta of 0.7. The risk free rate is 6 per cent and the expected
market risk premium is 6 per cent. What is Brooklyn’s required return?
market risk premium is 6 per cent. What is Brooklyn’s required return?
r = .06 + 0.7(.06)
r = .102 or 10.2%
r = .102 or 10.2%
3. Calculate Brooklyn’s betas assuming its return is expected to be 10.2% and
3. Calculate Brooklyn’s beta assuming its return is expected to be 10.2% and the risk free rate and market return are 6% and 12% respectively.
the risk free rate and market return are 6% and 12% respectively. .102 = .06 + β(.12 ‐ .06)
.102 = .06 + β × .06
.102 ‐ .06 = β × .06
.042/.06 = β
0.7 = β 0.7 = β
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Chapter 6: Bond Valuation Chapter 7: Share Valuation

• Coupon bond valuation; semi‐annual payments; • Efficient Market Hypothesis
• Yield to maturity (YTM) – use approximate YTM formula • Share valuation – Dividend models:
• Zero‐coupon bonds • Zero growth dividend model
• Interest rates, yield curves and the theories that explain them: • Constant growth dividend model
• Liquidity preference theory • Variable growth dividend model
• Expectations theory • Read the question carefully – has the dividend already been paid or is it
• Market segmentation theory a future dividend?
• Bond value behaviour: What happens to bond values (asset values in • Share valuation – Free Cash Flow (FCF) Valuation
general) when interest rates go up?, go down? • What discount rate should be used in dividend and FCF models?
• When is interest rate risk a problem for bondholders? • Other approaches to share valuation

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Integrative Question: Part 1 Integrative Question: Part 1

Brooklyn Ltd’s management has had no desire to seek out growth Brooklyn Ltd’s management has had no desire to seek out growth
opportunities for the past 10 years. During that period the company has opportunities for the past 10 years. During that period the company has
experienced steady cash flows and a dividend of $0.30 per year has been paid experienced steady cash flows and a dividend of $0.30 per year has been paid
out each year. Brooklyn has a beta of 0.7. The risk free rate is 6 per cent and out each year. Brooklyn has a beta of 0.7. The risk free rate is 6 per cent and
the expected market return is 12 per cent. What is Brooklyn’s share price? the expected market return is 12 per cent. What is Brooklyn’s share price?

A. Calculate Brooklyn Industries’ required return using the CAPM. A. Calculate Brooklyn Industries’ required return using the CAPM.
rj = RF + βj(rm – RF) rj = RF + βj(rm – RF)
rBrooklyn = .06 + 0.7(.12 ‐ .06)
rBrooklyn = .102 or 10.2% rBrooklyn = .102 or 10.2%

B. Calculate Brooklyn Industries’ share price assuming zero growth. B. Calculate Brooklyn Industries’ share price assuming zero growth.
D $0.30
P0 = = = $2.94
P0  $2.94 r 0.102

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 Integrative Question: Part 2 Integrative Question: Part 2
Now assume a new product technology graduate has devised a new system C. Recalculate the share price of Brooklyn Industries given this new
for the manufacture of the company’s major product. The efficiencies gained information. Assume that the required return is 10.2% and the last dividend
over the two (2) years will see the net cash flows of Brooklyn Industries grow paid was $0.30; g1,2 = 20%; g3 = 0%
by 20% in each year. Financial analysts believe that the dividend will increase
by 20% in each of the next two years and thereafter dividend growth will drop
back to zero.

C. Recalculate the share price of Brooklyn Industries given this new

information. Assume that the required return is 10.2% and the last
dividend paid was $0.30.

The steps:
1. Estimate the future cash flows 1. Estimate the future cash flows
2. Determine PV of future cash flows Div1 = $0.36
3. Add them up Div2 = $0.432. After that they will remain at $0.432 per annum.
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Integrative Question: Part 2 Integrative Question: Part 2

C. Recalculate the share price of Brooklyn Industries given this new 2. Present value of dividends in initial growth period are:
information. Assume that the required return is 10.2% and the last dividend
paid was $0.30. PV = $0.683
g1,2 = 20%
g3 = 0% Present value of all dividends after initial growth period

1. Estimate the future cash flows

Div1 = 0.30(1+.20) = $0.36
Div2 = 0.36(1+.20) = $0.432. After that they will remain at $0.432 per annum.
PV = $3.49

3. Adding them up we get $4.17

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Integrative Question: Part 2 Chapter 9: WACC

2. Present value of dividends in initial growth period are: • Same equations as Chapters 8 (CAPM), 6 and 7 but:
PV = FV(1+r)‐n • Chapters 6 and 7 look at valuation from the investors point of view, so
PV = 0.36(1.102)‐1 + 0.432(1.102)‐2 the “r” in the formulas is referred to investors’ required rate of return.
PV = 0.327 + 0.356 = $0.683 • Chapter 9 is from the company perspective. In Chapter 9 the company
has to pay this return. When you pay something it is a cost – hence the
same “r” is referred to as a cost in Chapter 9.
Present value of all dividends after initial growth period
• We solve for cost (i.e. r) not present value (i.e. P). If new securities are
D3 $0.432 being issued then we must replace current value (P0 or B0) with Nd,p,s which
P2 = = = 4.24
r-g 0.102 - 0.0 is the net proceeds the firm receives from selling debt or shares.
PV = FV(1+r)‐n
PV = 4.24(1.102)‐2
PV = $3.49

3. Adding them up we get 0.683 + 3.49 = $4.17

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 Integrative Question: Part 3 Integrative Question: Part 3
In order to fund the new system, Brooklyn Industries will issue new $1,000 In order to fund the new system, Brooklyn Industries will issue new $1,000
par value bonds with a coupon rate 8% and a maturity of 5 years. The net par value bonds with a coupon rate 8% and a maturity of 5 years. The net
proceeds will be $940 per bond after all issue costs. Brooklyn also has proceeds will be $940 per bond after all issue costs.
preference shares with a required return of 9.5%. The company tax rate is D. Estimate the cost of debt on the bonds using the approximate yield‐to‐
33% and Brooklyn Industries’ target capital structure is outlined below. maturity formula.

Source Proportion rd = 9.48%

Long‐term debt 40%
Preference share capital 10%
Ordinary share equity capital 50%

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Integrative Question: Part 3 Integrative Question: Part 3

In order to fund the new system, Brooklyn Industries will issue new $1,000 Brooklyn also has preference shares with a required return of 9.5%. The
par value bonds with a coupon rate 8% and a maturity of 5 years. The net company tax rate is 33% .
proceeds will be $940 per bond after all issue costs.
D. Estimate the cost of debt on the bonds using the approximate yield‐to‐ E. Calculate the WACC for Brooklyn Industries. For the cost of ordinary
maturity formula. shares use the required return calculated in A. above.

Source Weight Cost Weighted

Cost
Debt 0.40
Preference Shares 0.10
Ordinary Shares 0.50 0.102
WACC 0.0859

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Integrative Question: Part 3

Brooklyn also has preference shares with a required return of 9.5%. The
company tax rate is 33% .

E. Calculate the WACC for Brooklyn Industries. For the cost of ordinary
shares use the required return calculated in A. above.

Source Weight Cost Weighted

Cost
Debt 0.40 0.0948(1‐.33) 0.0254
Preference Shares 0.10 0.095 0.0095
Ordinary Shares 0.50 0.102 0.0510
WACC 0.0859

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