Birla Institute of Technology & Science, Pilani

ECON F 315 / FIN F 315 Financial Management

Mid-semester Test (Make-up) - 26 Apr 2018 Weight-age 30% (90 marks) Time 90 Mins.

1. Does the inclusion of a stock whose unique risk is high, relative to other assets, will always
increase the overall risk of the portfolio? Why or why not justify briefly (50-70 words). (6)

2. Given the following relationship between x and y, y=a+bx b<0 , show that standard deviation
of y is b times standard deviation of x. (7)

3. For the given variance-covariance matrix use the matrix approach to calculate (a) The variance of
an equally weighted portfolio (b) Covariance of a portfolio that has 10% in asset 1, 80% in asset 2,
and 10% in asset 3 with a second portfolio that has 125% in asset 1, -10% in asset, and remaining in
asset 3. (12)

24 -10 25
-10 75 32
25 32 12

4. 5. A company is expecting EBIT of Rs. 5,00,000 per annum on investment of Rs.

10,00,000. Company is in need of Rs. 8,00,000 for its expansion activities. Company can
raise this amount by either equity shares capital or 12% preference share capital or 10%
debentures. The company is considering the following financing patterns: (12)

1. 10,00,000 through  issue of Equity Shares at par;

2. 5,00,000 by issue of Equity Share Capital and remaining 5,00,000 by issue of
Debentures;
3. 5,00,000 through Equity Shares and 2,50,000 through 12% Preference Share Capital
and remaining 2,50,000 through 10% Debentures.;
4. 5,00,000 through Debt and 2,50,000 through Equity Shares and remaining 2,50,000
through 12% Preference Share Capital.

Find out the financing mix assuming 50% tax rate that maximizes the EPS.
Show calculation steps clearly.

5. Calculate the Weighted Average Cost of Capital for new firm ABC Ltd. The company is
in 30% tax bracket and the target capital structure post fund raising is 60% equity, 30% debt
and 10 % preferred stock. Assume floatation costs to be zero. (10)
a. Equity - Firm ABC Ltd. maintains a uniform dividend policy of 40% out of its
earnings and it is expected to continue for the foreseeable future. The most recent
EPS of the firm is Rs 6.5 and five years ago it was Rs 4.42. The stock is currently
trading at Rs 36.
b. Preferred stock – The firm will raise Rs 1,000,000 by issuing 10,000 at the rate
of 12% dividends and the redemption of preferred stock will be at the end of 5
years.
 c. Debt – Debt funding will be done through an issue of 8.5% debentures for 5
years. Similar bonds issued by other firms are trading at current YTM higher than
the coupon rate of 8.5%, hence, the firm is forced to issue debentures at 10%
discount to its face value. The firm is issuing 40,000 units of debentures.

6. Very briefly write your thoughts for or against (bullet points only) on the following:
a. Profit maximization is the best goal for the corporations whose stocks are publicly
traded.

b. Actions of the agents can cause principal-agent conflict.

c. There exists a trade-off between liquidity and profitability of a firm. (5*3)

7. Fund H has $10 million invested in long-term corporate bonds. This bond portfolio’s
expected annual rate of return is 9%, and the annual standard deviation is 10. Financial
advisor to Fund H recommends Fund H to consider investing in an index fund which closely
tracks S&P 500 index. The index has an expected return of 14 percent, and its standard
deviation is 16 percent.
a. Suppose Fund H puts all its money in a combination of the index fund and Treasure
bills. Can it thereby improve its expected rate of return without changing the risk of
the portfolio? The treasury bill yield is 6 percent.
b. Could Fund H do even better by investing equal amounts in the corporate bond
portfolio and the index fund. The correlation between the bond portfolio and the index
fund is +0.1 (10)

Multiple Choice Questions - 12 Questions of 1.5 marks each (no negative marking)

Write your answers in the table given:

1 2 3 4 5 6 7 8 9 10 11 12

1. In a typical loan amortization schedule:

a. Annual payments are constant, but principal repayment and interest
component increases
b. Annual payments are constant but principal component increases every year
and interest component decreases every year
c. Annual payments vary but principal component remains constant and interest
component decreases
d. Annual payments are constant but principal component reduces every year and
interest component increases every year
 e. Annual payments, principal repayment and interest component are all constant

2. If interest rates decrease subsequent to investor purchasing a bond, the investor is

said to be exposed to:
a. Interest rate risk
b. Reinvestment risk
c. Capital loss
d. Redemption risk
e. Default risk

3. The set appropriate assumptions for valuing a stock using dividend discount
approach of constant growth model are:
a. Dividend grows at a constant rate till perpetuity, the growth rate of earnings
always exceeds cost of capital; firm maintains a constant pay-out ratio
b. The cost of capital is always greater than the rate of extraordinary growth rate;
firm’s dividend policy is unchanged; firm is expected to continue paying
dividend till infinity
c. The dividend pay-out ratio is constant and less than the growth rate of firm’s
earnings; the firm’s RoE is constant; cost of capital always exceed growth rate
of dividends
d. Cost of capital is always greater than the dividend growth rate; the growth rate
of earnings is constant; dividend payout ratio is constant; retention ratio is
constant; the firm’s RoE is constant
e. Cost of capital is always greater than the dividend growth rate; the growth rate
of earnings is constant; dividend payout ratio is constant; growth rate in
extraordinary growth period is greater than growth rate in stable period; the
firm’s RoE is constant

4. A line that describes the relationship between an individual security’s returns and
returns on the market portfolio:
a. Characteristic line
b. Security market line
c. Capital market line
d. Beta
e. None

5. Which of the following would not improve the current ratio?

a. Borrow short term to finance additional fixed assets
b. Issue long-term debt to buy inventory
c. Sell common stocks to reduce current liability
d. Liquidate fixed assets to reduce accounts payable
e. Purchase marketable securities rather than investing in fixed assets
6. If the gross profit margin is unchanged while the net profit margin declined over
the same period you would suspect that:
a. The cost of goods sold has increased
b. Firm changed a lower rate of depreciation compared to last year
c. Firm paid less dividends
 d. The firm retired existing debt this year and thus did not get any tax shield
e. The firm’s sales increased and it paid higher taxes than last year
7. A firm can improve (lower) its debt-to-total assets ratio by doing which of the
following?
a. Borrow more at risk free rate
b. Sell common stock
c. Lend more at risk free rate
d. Shift short term to long term debt
e. Sell assets
8. If an investor believes in the basic principle of a risk-reward relationship, her
conclusion regarding security ratings and yields between an AAA bond and a AA
bond would be that:
a. Default risk differs but yields would equal
b. Default risk on AA bond will be greater than AAA bond and yield of AA bond
will be lower than AAA bond
c. AAA bond would have a lower default risk and higher yield compared to AA
bond
d. AAA bond would have the lower yield and lower default risk than AA bond
e. AA bond would have the lower yield than AAA bond
9. All of the following are true of stock splits except:
a. Market price per share is reduced after the split
b. The number of outstanding shares is increased
c. Retained earnings are changed
d. Proportional ownership is unchanged
e. The capital structure is not affected
10. If a firm repurchases 50 percent of its outstanding shares in the open (secondary)
market the result would be:
a. A decline in its assets
b. A decline in EPS
c. An increase in cash
d. An increase in number of stockholders
e. A fall in liability
11. What does the importance of ethical behavior, integrity and trust call into
question?
a. What do we do next
b. Who does what
c. The extent to which management should attempt to change the underlying
beliefs and values of individual followers
d. None of the above
e. All of the above
12. If A is the price of an ordinary share, B is the expected dividend in one year’s
time, and C is the expected constant annual growth rate, what is the equation for
deducing the cost of an ordinary share (D)?
a. D = (B/A) – C
b. D = B/A +C
c. D = A/(B-C)
d. D = A/(B+C)
e. None
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