FINA2010

Financial Management

Revision for Final Exam

Question 1:

Kaaran made a friendly wager with a colleague that involves the result from flipping a coin. If heads comes up,
Kaaran must pay her colleague $15; otherwise, her colleague will pay Kaaran $15. What is Kaaran’s expected
cash flow, and what is the variance of that cash flow if the coin has an equal probability of coming up heads or
tails? Suppose Kaaran’s colleague is willing to handicap the bet by paying her $20 if the coin toss results in
tails. If everything else remains the same, what are Kaaran’s expected cash flow and the variance of that cash
flow?

Solution:

Part 1: E(cash flow) = (0.5 × –$15) + (0.5 × $15) = 0

σ2cash flow = [0.5 × (–$15 - $0)2] + [0.5 × ($15 – $0)2] = $225

Part 2: E(cash flow) = (0.5 × –$15) + (0.5 × $20) = $2.50

σ2cash flow = [0.5 × (–$15 – $2.50)2] + [0.5 × ($20 – $2.50)2] = $306.25

Question 2:

For each year from 2015 through 2019, the annual returns on small U.S. stocks were −3.60 percent, 25.65
percent, 11.19 percent, −11.60 percent, and 20.63 percent, respectively. What would a $1 investment, made at
the beginning of 2015, have been worth at the end of 2019? What average annual return would have been earned
on this investment?

Solution:

The value in 2019 is:

V2019 = $1 × (1 + −0.036) × (1 + 0.2565) × (1 + 0.1119) × (1 + -0.1160) × (1 + 0.2063)

= $1.436
 Substituting into Equation 7.4 and solving for the geometric average yields:

RGeometric average = [(1 + R1) × (1 + R2) × … × (1 + Rn)]1/n – 1

= [$1.436]1/5 - 1

= 0.0751, or 7.51% per year

Question 3:

You have been provided with the following information about the expected returns to Stock A and Stock B for
various possible future economic conditions.

State of Probability of State of Return for Stock Return for Stock

Economy Economy A B
Boom 0.25 0.25 0.45
Level 0.60 0.35 0.12
Slump 0.15 0.10 -0.10

The market risk premium is 7 percent, and the risk-free rate is 4 percent.

a. Which stock has more systematic risk?

b. Which stock has more unsystematic risk?
c. Which stock is “riskier” and why?
Solutions:

Using Equation 7.2 you can calculate the expected return for both stocks.

E(RA) = [(0.25) × (0.25)] + [(0.60) × (0.35)] + [(0.15) × (0.10)] = 0.2875

E(RB) = [(0.25) × (0.45)] + [(0.60) × (0.12)] + [(0.15) × (-0.10)] = 0.1695

To calculate the amount of systematic risk we can use their expected returns and equation 7.12 to solve
for the beta of each stock.

E(RA) = Rrf + βA (E(Rm) – Rrf)

0.2875 = 0.04 + (βA × 0.07)

βA = 3.54

E(RB) = Rrf + βB (E(Rm) – Rrf)

 0.1695 = 0.04 + (βB × 0.07)

βB = 1.85

(a) Stock A has more systematic risk because it has a higher beta.
Using Equation 7.3 we can calculate the variance of both stocks.

σ2A = [(0.25) × (0.25 – 0.2875)2] + [(0.60) × (0.35 – 0.2875)2] + [(0.15) × (0.10 – 0.2875)2]

= 0.0080

σ2B = [(0.25) × (0.45 – 0.1695)2] + [(0.60) × (0.12 – 0.1695)2 ] + [(0.15) × (-0.10 – 0.1695)2]

= 0.0320

(b) Stock B has more total risk as measured by the variance of returns; however, Stock B has less
systematic risk than Stock A as measured by the beta. Thus, Stock B must have more unsystematic
risk that can be diversified away in a large portfolio.

(c) Stock A is riskier since it has more systematic risk, which is the measure of risk that investors care
about because it can’t be diversified away in a large portfolio.

Question 4:

ACME Manufacturing is considering replacing an existing production line with a new line that has a greater
output capacity and operates with less labor than the existing line. The new line would cost $1 million, have a
five-year life, and be depreciated using the MACRS three-year schedule. At the end of five years, the new line
could be sold as scrap for $200,000 (in Year 5 dollars). Because the new line is more automated, it would require
fewer operators, resulting in a savings of $40,000 per year before tax and unadjusted for inflation (in today’s
dollars). Additional sales with the new machine are expected to result in additional net cash inflows, before tax,
of $60,000 per year (in today’s dollars). If ACME invests in the new line, a one-time investment of $10,000 in
additional working capital will be required. The working capital investment will be recovered at the end of the
project's life. The tax rate is 28 percent, the opportunity cost of capital is 10 percent, and the annual rate of
inflation is 3 percent. What is the NPV of the new production line?

Solution:

$167, 484 $200,845 $120,144 $101,785 $237, 468

NPV = −$1,010,000 + + + + +
(1.10 ) (1.10 )
2
(1.10 )
3
(1.10 )
4
(1.10 )
5

= −$384,519
Time, years 0 1 2 3 4 5

Incremental
Revenue 61,800 63,654 65,564 67,531 69,556

Savings 41,200 42,436 43,709 45,020 46,371

Depreciation 333,300 444,500 148,100 74,100 0

Earnings before taxes (230,300) (338,410) (38,827) 38,451 115,927

Taxes (64,484) (94,755) (10,872) 10,766 32,460

Net income (165,816) (243,655) (27,956) 27,685 83,468

Net operating cash flow 167,484 200,845 120,144 101,785 83,468

Cost of new machine (1,000,000)

Investment in working capital (10,000) 10,000

Terminal value

Market value 200,000

Book value 0
Taxes 56,000

Terminal after tax cash flow 144,000

Free cash flow (1,010,000) 167,484 200,845 120,144 101,785 237,468

Project NPV (384,519)

Question 5:

FITCO is considering the purchase of new equipment. The equipment costs $350,000, and an additional
$110,000 is needed to install it. The equipment will be depreciated straight-line to zero over a five-year
life. The equipment will generate additional annual revenues of $265,000, and it will have annual cash
operating expenses of $83,000. The equipment will be sold for $85,000 after five years. An inventory
investment of $73,000 is required during the life of the investment. FITCO has a marginal tax rate of
28 percent, and its cost of capital is 10 percent. What is the project’s NPV?

Solution:
The installed cost of the equipment is $350,000 + $110,000 = $460,000.
The initial increase in Net working capital is $73,000.
Annual depreciation is $460,000/5 = $92,000
The annual after-tax operating cash flow for Years 1–5 is
CF = (Sales – Costs – Deprec) x (1 – T) + Deprec
= (265,000 – 83,000 – 92,000) x (1 – 0.28) + 92,000
CF = $156,800

After tax cash flow from selling equipment:

Sales price 85,000

Book value at project

end 0

Gain on Sale 85,000

Tax on Gain 23,800

Net ATCF on Sale 61,200

The return of working capital is $73,000

 0 1 2 3 4 5

Revenue $265,000 $265,000 $265,000 $265,000 $265,000

−Op Ex 83,000 83,000 83,000 83,000 83,000

EBITDA 182,000 182,000 182,000 182,000 182,000

−D&A 92,000 92,000 92,000 92,000 92,000

EBIT 90,000 90,000 90,000 90,000 90,000

×(1 − t) 0.72 0.72 0.72 0.72 0.72

NOPAT 64800 64,800 64,800 64,800 64,800

+D&A 92,000 92,000 92,000 92,000 92,000

CF Opns 156,800 156,800 156,800 156,800 156,800

−Cap Exp -460,000 61,200

−Add WC -73,000 0 73,000

FCF -533,000 156,800 156,800 156,800 156,800 291,000

NPV@10% 144,723

Question 6:

You have just encountered two identical firms with identical investment opportunities, as well as the
ability to fund these opportunities. One of the firms has just announced that it will pay a dividend, while
the other has continued to pay no dividend. Which of the two firms is worth more under the M&M
assumptions? Explain.

Solution:

Neither, the two firms are worth the same. If we begin with a world described by the Modigliani
and Miller paper in 1961, which assumes that (1) investors incur no taxes, (2) there are no
information or transactions costs, and (3) the dividend payout rates have no effect on the firm’s
real investment policy, then both firms will be worth exactly the same. That is because investors
who want dividends but own a no-dividend stock can liquidate their appreciated value shares
to create a homemade dividend, and shareholders who do not want dividends but own a
dividend-paying stock can use their “unwanted” dividends to purchase additional shares of that
 stock. However, since M&M assumptions do not apply in the real world, dividend decisions
made by the firm and investor preferences can influence its value.

Question 7:

CashCo increased its cash dividend each quarter for the past eight quarters. While this may signal that
the firm is financially very healthy, what else could we conclude from these actions?

Solution:

If we rule out the possibility that the firm is just producing a high level of cash, then we must
conclude that the firm has more cash than it has investment opportunities to utilize that cash. In
short, we might conclude that the firm’s growth rate will be slowing down in the future.

Question 8:

Undecided Corp. has excess cash on hand right now, although management is not sure about the level
of cash flows going forward. If management would like to put ash in stockholders’ hands, what kind of
dividend should the firm pay, and why?

Solution:

Since this is a one-time increase in cash flow, the firm would not want to commit to an ongoing
higher dividend rate. If the firm went that route but then later had to reduce the dividend back
to current dividend levels, then the market could interpret that action as indecision on the part
of management, or worse. Therefore, an increase in the regular dividend would not be
appropriate. A more appropriate choice would be to declare an extra dividend. Note that it would
be called a special dividend if the extra cash flow came from something other than the firm’s
regular operations or if the cash were an unusually large amount.