AUBG State Exam Preparation Finance

State Exam in Finance - Review Problems

The following review problems are meant to serve as a guide for students taking the State Exam
in finance. The problems cover six major subjects of Corporate Finance I (BUS 330). While
these problems can be referred to a practice guide, they are not necessarily inclusive to the
entire material that students are responsible for to prepare for the exam.

1. Time value of money and valuing cash flow streams

This is a classic retirement problem. A time line will help in solving it. Your friend is celebrating her 35th
birthday today and wants to start saving for her anticipated retirement at age 65. She wants to be able to
withdraw $105,000 from her savings account on each birthday for 20 years following her retirement; the
first withdrawal will be on her 66th birthday. Your friend intends to invest her money in the local credit
union, which offers 7 percent interest per year. She wants to make equal annual payments on each
birthday into the account established at the credit union for her retirement fund.

a. If she starts making these deposits on her 36th birthday and continues to make deposits until she is 65
(the last deposit will be on her 65th birthday), what amount must she deposit annually to be able to
make the desired withdrawals at retirement?

b. Suppose your friend’s employer will contribute $3,500 to the account every year as part of the
company’s profit-sharing plan. In addition, your friend expects a $175,000 distribution from a family trust
fund on her 55th birthday, which she will also put into the retirement account. What amount must she
deposit annually now to be able to make the desired withdrawals at retirement?

Solution

Here we are solving a two-step time value of money problem. Each question asks for a different possible
cash flow to fund the same retirement plan. Each savings possibility has the same FV, that is, the PV
of the retirement spending when your friend is ready to retire. The time line for the amount needed at
retirement is:

30 31 50
…
$105,000 $105,000 $105,000 $105,000 $105,000 $105,000 $105,000 $105,000 $105,000

The amount needed when your friend is ready to retire is:

PVA = $105,000{[1 – (1/1.0720)] / .07} = $1,112,371.50

This amount is the same for all three parts of this question.

a. If your friend makes equal annual deposits into the account, this is an annuity with the FVA equal
to the amount needed in retirement. The time line is:

0 1 30
…
C C C C C C C C C
$1,112,371.50

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The required savings each year will be:

FVA = $1,112,371.50 = C[(1.0730 – 1) / .07]

C = $11,776.01

c. In this problem, we have a lump sum savings in addition to an annual deposit. The time line is:

0 1 10 30
… …
–$175,000 $1,112,371.50
–$3,500 –$3,500 –$3,500 –$3,500 –$3,500 –$3,500 –$3,500 –$3,500
C C C C C C C C

Since we already know the value needed at retirement, we can subtract the value of the lump sum
savings at retirement to find out how much your friend is short. Doing so gives us:

FV of trust fund deposit = $175,000(1.07)10 = $344,251.49

So, the amount your friend still needs at retirement is:

FV = $1,112,371.50 – 344,251.49 = $768,120.01

Using the FVA equation, and solving for the payment, we get:

$768,120.01 = C[(1.07 30 – 1) / .07]

C = $8,131.63

This is the total annual contribution, but your friend’s employer will contribute $3,500 per year,
so your friend must contribute:

Friend's contribution = $8,131.63 – 3,500 = $4,631.63.

2. Bond Valuation

2.1 Bond Price Movements. Bond X is a premium bond making semiannual payments. The bond pays a
coupon rate of 8.5 percent, has a YTM of 7 percent, and has 13 years to maturity. Bond Y is a discount
bond making semiannual payments. This bond pays a coupon rate of 7 percent, has a YTM of 8.5 percent,
and also has 13 years to maturity. What is the price of each bond today? If interest rates remain
unchanged, what do you expect the price of these bonds to be one year from now? In three years? In eight
years? In 12 years? In 13 years? What’s going on here? Illustrate your answers by graphing bond prices
versus time to maturity.

2.2 Components of Bond Returns. Bond P is a premium bond with a coupon rate of 10 percent. Bond D
has a coupon rate of 4 percent and is currently selling at a discount. Both bonds make annual payments,

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have a YTM of 7 percent, and have 10 years to maturity. What is the current yield for bond P? For bond
D? If interest rates remain unchanged, what is the expected capital gains yield over the next year for bond
P? For bond D? Explain your answers and the interrelationships among the various types of yields.

Solution

2.1. Here we are finding the YTM of annual coupon bonds for various maturity lengths. The bond price
equation is:

P = C(PVIFAR%,t) + $1,000(PVIFR%,t)

X: P0 = $42.50(PVIFA3.5%,26) + $1,000(PVIF3.5%,26) = $1,126.68

P1 = $42.50(PVIFA3.5%,24) + $1,000(PVIF3.5%,24) = $1,120.44
P3 = $42.50(PVIFA3.5%,20) + $1,000(PVIF3.5%,20) = $1,106.59
P8 = $42.50(PVIFA3.5%,10) + $1,000(PVIF3.5%,10) = $1,062.37
P12 = $42.50(PVIFA3.5%,2) + $1,000(PVIF3.5%,2) = $1,014.25
P13 = $1,000
Y: P0 = $35(PVIFA4.25%,26) + $1,000(PVIF4.25%,26) = $883.33
P1 = $35(PVIFA4.25%,24) + $1,000(PVIF4.25%,24) = $888.52
P3 = $35(PVIFA4.25%,20) + $1,000(PVIF4.25%,20) = $900.29
P8 = $35(PVIFA4.25%,10) + $1,000(PVIF4.25%,10) = $939.92
P12 = $35(PVIFA4.25%,2) + $1,000(PVIF4.25%,2) = $985.90
P13 = $1,000

Maturity and Bond Price

$1,300

$1,200

$1,100
Bond Price

$1,000
Bond X
$900 Bond Y

$800

$700
13 12 11 10 9 8 7 6 5 4 3 2 1 0
Maturity (Years)

All else held equal, the premium over par value for a premium bond declines as maturity approaches,
and the discount from par value for a discount bond declines as maturity approaches. This is called
“pull to par.” In both cases, the largest percentage price changes occur at the shortest maturity
lengths.

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Also, notice that the price of each bond when no time is left to maturity is the par value, even though
the purchaser would receive the par value plus the coupon payment immediately. This is because we
calculate the clean price of the bond.

2.2 To find the capital gains yield and the current yield, we need to find the price of the bond. The current
price of Bond P and the price of Bond P in one year are:

P: P0 = $100(PVIFA7%, 10) + $1,000(PVIF7%, 10) = $1,210.71

P1 = $100(PVIFA7%, 9) + $1,000(PVIF7%,9) = $1,195.46

So, the capital gains yield is:

Capital gains yield = (New price – Original price) / Original price

Capital gains yield = ($1,195.46 – 1,210.71) / $1,210.71
Capital gains yield = –.0126, or –1.26%

And the current yield is:

Current yield = $100 / $1,210.71

Current yield = .0826, or 8.26%

The current price of Bond D and the price of Bond D in one year is:

D: P0 = $40(PVIFA7%, 10) + $1,000(PVIF7%, 10) = $789.29

P1 = $40(PVIFA7%, 9) + $1,000(PVIF7%, 9) = $804.54

So, the capital gains yield is:

Capital gains yield = ($804.54 – 789.29) / $789.29

Capital gains yield = .0193, or 1.93%

And the current yield is:

Current yield = $40 / $789.29

Current yield = .0507, or 5.07%

All else held constant, premium bonds pay high current income while having price depreciation as
maturity nears; discount bonds do not pay high current income but have price appreciation as
maturity nears. For either bond, the total return is still 7 percent, but this return is distributed
differently between current income and capital gains.

3. Stock Valuation

3.1 Capital Gains versus Income. Consider four different stocks, all of which have a required return of
15 percent and a most recent dividend of $3.75 per share. Stocks W, X, and Y are expected to maintain
constant growth rates in dividends for the foreseeable future of 10 percent, 0 percent, and −5 percent per
year, respectively. Stock Z is a growth stock that will increase its dividend by 20 percent for the next two

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years and then maintain a constant 5 percent growth rate thereafter. What is the dividend yield for each of
these four stocks? What is the expected capital gains yield? Discuss the relationship among the various
returns that you find for each of these stocks.

3.2 Two-Stage Dividend Growth Model. Numerica Corp. just paid a dividend of $1.55 per share. The
dividends are expected to grow at 27 percent for the next eight years and then level off to a growth rate of
3.5 percent indefinitely. If the required return is 12 percent, what is the price of the stock today?

Solution

3.1 We are asked to find the dividend yield and capital gains yield for each of the stocks. All of the stocks
have a required return of 15 percent, which is the sum of the dividend yield and the capital gains
yield. To find the components of the total return, we need to find the stock price for each stock.
Using this stock price and the dividend, we can calculate the dividend yield. The capital gains yield
for the stock will be the total return (required return) minus the dividend yield.

W: P0 = D0(1 + g) / (R – g) = $3.75(1.10) / (.15 – .10) = $82.50

Dividend yield = D1 / P0 = $3.75(1.10) / $82.50 = .05, or 5%

Capital gains yield = .15 – .05 = .10, or 10%

X: P0 = D0(1 + g) / (R – g) = $3.75 / (.15 – 0) = $25.00

Dividend yield = D1 / P0 = $3.75 / $25.00 = .15, or 15%

Capital gains yield = .15 – .15 = 0%

Y: P0 = D0(1 + g) / (R – g) = $3.75(1 – .05) / (.15 + .05) = $17.81

Dividend yield = D1 / P0 = $3.75(.95) / $17.81 = .20, or 20%

Capital gains yield = .15 – .20 = –.05, or –5%

Z: P2 = D2(1 + g) / (R – g) = D0(1 + g1)2(1 + g2) / (R – g2)

P2 = $3.75(1.20)2(1.05) / (.15 – .05) = $56.70

P0 = $3.75 (1.20) / (1.15) + $3.75 (1.20)2 / (1.15)2 + $56.70 / (1.15)2 = $50.87

Dividend yield = D1 / P0 = $3.75(1.20) / $50.87 = .088, or 8.8%

Capital gains yield = .15 – .088 = .062, or 6.2%

In all cases, the return is 15 percent, but the return is distributed differently between current income
and capital gains. High growth stocks have an appreciable capital gains component but a relatively
small current income yield; conversely, mature, negative-growth stocks provide a high current
income but also price depreciation over time.

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3.2. We can use the two-stage dividend growth model for this problem, which is:

P0 = [D0(1 + g1)/(R – g1)]{1 – [(1 + g1)/(1 + R)]t}+ [(1 + g1)/(1 + R)]t[D0(1 + g2)/(R – g2)]
P0 = [$1.55(1.27)/(.12 – .27)][1 – (1.27/1.12)8] + [(1.27)/(1.12)]8[$1.55(1.035)/(.12 – .035)]
P0 = $74.33

4. Investment decisions and capital budgeting

4.1 Project Evaluation. Daniel Franks is looking at a new sausage system with an installed cost of
$540,000. This cost will be depreciated straight-line to zero over the project’s five-year life, at the end of
which the sausage system can be scrapped for $80,000. The sausage system will save the firm $170,000
per year in pretax operating costs, and the system requires an initial investment in net working capital of
$29,000. If the tax rate is 34 percent and the discount rate is 10 percent, what is the NPV of this project?

4.2 Comparing Mutually Exclusive Projects. Innova Industries is considering the purchase of a new
machine for the production of latex. Machine A costs $2,600,000 and will last for six years. Variable
costs are 35 percent of sales, and fixed costs are $195,000 per year. Machine B costs $5,200,000 and will
last for nine years. Variable costs for this machine are 30 percent of sales and fixed costs are $230,000 per
year. The sales for each machine will be $10 million per year. The required return is 10 percent, and the
tax rate is 35 percent. Both machines will be depreciated on a straight-line basis. If the company plans to
replace the machine when it wears out on a perpetual basis, which machine should you choose?

Solution

4.1 First we will calculate the annual depreciation of the new equipment. It will be:

Annual depreciation = $540,000 / 5

Annual depreciation = $108,000

Now, we calculate the aftertax salvage value. The aftertax salvage value is the market price minus
(or plus) the taxes on the sale of the equipment, so:

Aftertax salvage value = MV + (BV – MV)TC

Very often the book value of the equipment is zero as it is in this case. If the book value is zero, the
equation for the aftertax salvage value becomes:

Aftertax salvage value = MV + (0 – MV)TC

Aftertax salvage value = MV(1 – TC)

We will use this equation to find the aftertax salvage value since we know the book value is zero. So,
the aftertax salvage value is:

Aftertax salvage value = $80,000(1 – .34)

Aftertax salvage value = $52,800

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Using the tax shield approach, we find the OCF for the project is:

OCF = $170,000(1 – .34) + .34($108,000)

OCF = $148,920

Now we can find the project NPV. Notice we include the NWC in the initial cash outlay. The
recovery of the NWC occurs in Year 5, along with the aftertax salvage value.

NPV = –$540,000 – 29,000 + $148,920(PVIFA10%,5) + [($52,800 + 29,000) / 1.105]

NPV = $46,315.33

4.2. Since we need to calculate the EAC for each machine, sales are irrelevant. EAC only uses the costs
of operating the equipment, not the sales. Using the bottom-up approach, or net income plus
depreciation, method to calculate OCF, we get:

Machine A Machine B
Variable costs –$3,500,000 –$3,000,000
Fixed costs –195,000 –230,000
Depreciation –433,333 –577,778
EBT –$4,128,333 –$3,807,778
Tax 1,444,917 1,332,722
Net income –$2,683,417 –$2,475,056
+ Depreciation 433,333 577,778
OCF –$2,250,083 –$1,897,278

The NPV and EAC for Machine A are:

NPVA = –$2,600,000 – $2,250,083(PVIFA10%,6)

NPVA = –$12,399,699.51

EACA = – $12,399,699.51 / (PVIFA10%,6)

EACA = –$2,847,062.52

And the NPV and EAC for Machine B are:

NPVB = –$5,200,000 – 1,897,278(PVIFA10%,9)

NPVB = –$16,126,467.91

EACB = – $16,126,467.91 / (PVIFA10%,9)

EACB = –$2,800,208.58

You should choose Machine B since it has a more positive EAC.

5. Risk and return in capital markets

5.1 Using CAPM . A stock has a beta of 1.14 and an expected return of 10.5 percent. A risk-free asset
currently earns 2.4 percent.

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a. What is the expected return on a portfolio that is equally invested in the two assets?
b. If a portfolio of the two assets has a beta of .92, what are the portfolio weights?
c. If a portfolio of the two assets has an expected return of 9 percent, what is its beta?
Solution 5.1
a. We have a special case where the portfolio is equally weighted, so we can sum the returns of
each asset and divide by the number of assets. The expected return of the portfolio is:

E(RP) = (.105 + .024) / 2

E(RP) = .0645, or 6.45%

b. We need to find the portfolio weights that result in a portfolio with a  of .92. We know the 
of the risk-free asset is zero. We also know the weight of the risk-free asset is one minus the
weight of the stock since the portfolio weights must sum to one, or 100 percent. So:

P = .92 = wS(1.14) + (1 – wS)(0)

.92 = 1.14wS + 0 – 0wS
wS = .92 / 1.14
wS = .8070

And, the weight of the risk-free asset is:

wRf = 1 – .8070
wRf = .1930

c. We need to find the portfolio weights that result in a portfolio with an expected return of 9
percent. We also know the weight of the risk-free asset is one minus the weight of the stock
since the portfolio weights must sum to one, or 100 percent. So:

E(RP) = .09 = .105wS + .024(1 – wS)

.09 = .105wS + .024 – .024wS
.066 = .081wS
wS = .8148

So, the  of the portfolio will be:

P = .8148(1.14) + (1 – .8148)(0)
P = .929

6. Cost of capital

6.1 Finding the WACC. Given the following information for Wilson Power Co., find the weighted average
cost of capital (WACC). Assume the company’s tax rate is 35 percent.

Debt: 10,000, 6.4 percent coupon bonds outstanding, $1,000 par value, 25 years to maturity, selling for 108
percent of par; the bonds make semiannual payments.
Common 495,000 shares outstanding, selling for $63 per share; the beta is 1.15.
stock:
Preferred 35,000 shares of 3.5 percent preferred stock outstanding, currently selling for $72 per share.

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stock:
Market: 7 percent market risk premium and 3.2 percent risk-free rate.

Solution 6.1

We will begin by finding the market value of each type of financing. We find:

MVD = 10,000($1,000)(1.08) = $10,800,000

MVE = 495,000($63) = $31,185,000
MVP = 35,000($72) = $2,520,000

And the total market value of the firm is:

V = $10,800,000 + 31,185,000 + 2,520,000

V = $44,505,000

Now, we can find the cost of equity using the CAPM. The cost of equity is:

RE = .032 + 1.15(.07)
RE = .1125, or 11.25%

The cost of debt is the YTM of the bonds, so:

P0 = $1,080 = $32(PVIFAR%,50) + $1,000(PVIFR%,50)

R = 2.895%
YTM = 2.895% × 2 = 5.79%

And the aftertax cost of debt is:

RD = (1 – .35)(.0579)
RD = .0376, or 3.76%

The cost of preferred stock is:

RP = $3.50 / $72
RP = .0486, or 4.86%

Now we have all of the components to calculate the WACC. The WACC is:

WACC = .0376($10,800,000 / $44,505,000) + .1125($31,185,000 / $44,505,000)

+ .0486($2,520,000 / $44,505,000)
WACC = .0907, or 9.07%

Notice that we didn’t include the (1 – TC) term in the WACC equation. We used the aftertax cost of
debt in the equation, so the term is not needed here.