Corporate Finance

Week 1
Practice Problems
Solutions

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2020-07-16
Corporate Finance Week 1— Practice Problem Solutions

WEEK 1 — PRACTICE PROBLEM SOLUTIONS

Solution to Practice Problem 1: Multiple-choice question

Option c) is correct. Under market efficiency, the price will rapidly and correctly adjust
to reflect new information.

Option a) is incorrect. The adjustment in price should be correct, not excessive.

Option b) is incorrect. The adjustment in price should be rapid.
Option d) is incorrect. The price should adjust to all relevant information.

Source: Topic 1.2-1

Solution to Practice Problem 2

The three primary or basic roles of the financial executive are as follows:
1. Investment: deciding what capital investments (in the non-current or productive
assets) to make
2. Financing: deciding how to finance the firm, otherwise known as the firm’s capital
structure, as well as how to finance future capital investments
3. Management of daily financial activities (working capital): managing the firm’s
current assets and current liabilities

The financial executive’s primary goal is to maximize shareholders’ wealth, which is

measured by the price of the share. If the value of the organization is maximized, then
the wealth of the owners will be maximized.

Source: Topic 1.1

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Solution to Practice Problem 3

Financial markets perform a number of functions. First, they help the trading of new
securities, which companies issue to raise investment capital. Financial markets are
classified as primary or secondary: primary markets focus on the sale of new securities;
secondary markets focus on the trade of existing securities. (Secondary markets help
the primary markets to function properly.)

Second, financial markets efficiently match the buyers and sellers of securities.

Third, by matching buyers and sellers, financial markets foster the formation of capital
and growth of the economy. It is an efficient system for issuers to raise the capital they
require.

Source: Topic 1.2

Solution to Practice Problem 4

The decline in the stock price is consistent with the semi-strong form of the efficient
market hypothesis (EMH), as information about both the slowdown in the economy and
the firm’s declining sales is in the public domain. This negative information led to a
decline in the stock price.

Source: Topic 1.2-1

Solution to Practice Problem 5

CPA Way step: Assess the Situation

HI is looking to raise new funds and is considering issuing either bonds or preferred
shares. Currently, it has a loan covenant that requires the company’s debt-to-equity
ratio to be less than 1.8; its current debt-to-equity ratio is already at 1.5. Management
anticipates that revenues (and therefore cash inflows) in the coming year will be lower
than originally forecast.

Consequently, the option chosen should conserve cash as much as possible for at least
the coming year and should not cause HI to breach its current loan covenant.

As requested, the differences and similarities of each proposed source of capital have
been assessed. In addition, the impact on the loan covenant and future cash flows has
also been discussed.

CPA Way step: Analyze Major Issue(s)

Below is a summary of similarities and differences between bonds and preferred

shares.

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Corporate Finance Week 1— Practice Problem Solutions

Stated or fixed payments: Both bonds and preferred shares usually have a stated or
fixed payment rate. The difference is that for a bond, the issuer is obligated (by contract)
to make the stipulated interest payments, whereas the firm can decide not to pay
preferred-share dividends, at least until it has enough cash to make the payment.
Therefore, with respect to future cash outflows, the preferred shares option allows HI to
postpone making dividend payments in any year.

Trading: Both bonds and preferred shares are issued in the primary market and trade in
the secondary market. The difference is that bonds trade in dealer (OTC) markets,
whereas preferred shares are traded on both exchanges and OTC.

Tax deductibility: Interest payments on bonds are a tax-deductible expense for the
issuing company, whereas the dividends on preferred shares are not. HI must pay these
dividends out of after-tax earnings.

Maturity: Bonds have a stipulated term to maturity, and at maturity, the issuing firm must
repay the principal to the investors. In contrast, preferred shares are seen as a form of
permanent financing because there is no maturity date and, therefore, no need to repay
the principal in the future. The maturity of bonds will impact future cash outflows
because these repayments cannot be deferred. The preferred shares have no
repayment requirement and therefore are the better alternative to conserve future cash
flows. HI can repurchase these shares when it is advantageous, if ever.

Priority: For HI, both the bond and the preferred shares take priority over common
shares. However, bonds take priority over preferred shares. Bonds usually require
periodic payments — the firm must pay interest before paying any dividends. It must
also repay the principal; therefore, bonds have a higher claim to the firm’s assets. As
such, should HI have insufficient cash to make the required bond payments, the
creditors could force the company to pay.

Rating services: Both bonds and preferred shares can be rated by rating services such
as the Canadian Bond Rating Service (CBRS) or the Dominion Bond Rating Service
(DBRS). You can often find the rating for the bonds and preferred shares of
governments and major corporations.

Sweeteners: Both bonds and preferred shares can be issued with sweeteners. A
conversion feature or a call feature are two examples of sweeteners.

Impact on covenant: Bonds must be reported as debt, and therefore any new bond
issue will increase the debt-to-equity ratio and may breach the loan covenant if the
revised debt-to-equity ratio is higher than 1.8. The preferred shares are reported as
equity and therefore will reduce the debt-to-equity ratio. As such, the preferred-share
issue is the better alternative to ensure the company maintains compliance with the
covenant.

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Corporate Finance Week 1— Practice Problem Solutions

CPA Way step: Conclude and Advise

The company should issue preferred shares to raise this new capital to ensure that the
loan covenant remains below 1.8. The preferred shares are also the better alternative to
conserve cash in the coming year. While the cost of preferred shares is generally higher
than the cost of bonds, the current economic situation (fluctuating cash flows) and bond
covenants make this additional cost worthwhile.

Source: Topics 1.3-2 and 1.3-3

Solution to Practice Problem 6

a) Retractable bonds provide bondholders with the right to sell the bond back to the
issuer at a predetermined price at specific times prior to maturity. Extendible bonds
provide the bondholders with the opportunity to extend the term of the bond beyond
the maturity date at a price that is previously agreed upon. The investor is protected
against changing interest rates as these options add flexibility, and because of this
protection, investors are willing to pay more for these bonds, which translates into
lower yields.

b) Callable bonds give the firm the option of calling or buying back bonds from
investors at call prices that are previously agreed upon. The firm benefits if interest
rates decline because it can repurchase the bonds and issue new bonds carrying
lower coupon rates. The firm is willing to set a call premium or pay a value higher
than the face value for these bonds when they call them because of this possibility. It
also compensates the investors for the extra risk they take on — the risk of the firm
calling back the bonds if interest rates fall. This is a risk to the investor because
falling interest rates mean the market value of the bond they own rises. The firm will
only call the bonds when the falling interest rates have pushed the market value of
the bonds to above the call premium. Thus, the investors lose out on this higher
market value along with lower returns when they reinvest the bond proceeds. Due to
this increased risk investors demand a higher rate of return. When a bond issue has
what is known as a “Canada call feature,” investors do not face this risk. In this case,
firms will only refinance an outstanding bond issue for reasons other than a change
in market rates, because when the bonds are called, a call premium is required that
compensates the bondholder for the difference in bond value generated by the
change in market interest rates since the bond was issued.

Source: Topic 1.3-2

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Corporate Finance Week 1— Practice Problem Solutions

Solution to Practice Problem 7

The term structure of interest rates (also called the yield curve) is a comparison of the
yield to maturity on risk-free securities as a function of different terms to maturity. You
can use the term structure as a starting point to estimate the required return for long-
term securities.

Source: Topic 1.4-2

Solution to Practice Problem 8

a) The nominal interest rate is 6.6%. Use the Fisher equation:
Nominal rate = [(1 + Real rate) × (1 + Expected inflation rate)] – 1
= 1.025 × 1.04 – 1 = 0.066 = 6.6%

b) The underlying real interest rate is 1.90%. Rearrange the Fisher equation:
Real rate = (1 + Nominal rate) ÷ (1 + Expected inflation rate) – 1
= (1.07 ÷ 1.05) – 1 = 0.0190 = 1.9%

c) If the expected inflation increases by 1%, real interest rates will not change because
expected inflation is not a part of the real interest rate. Nominal interest rates will
increase by slightly more than 1%, although the exact increase will depend on real
interest rates and the previous level of expected inflation. As an example, assume
the real interest rate is 3%, and the previous expected inflation was 2%. Based on
the Fisher equation, nominal interest rates will increase by 1.03%:
[1.03 × (1.02 + 0.01)] – 1 = 0.0609 versus (1.03 × 1.02) – 1 = 0.0506

Source: Topic 1.4-3

Solution to Practice Problem 9

a) An efficient market is important to investors because it gives them the confidence to
buy long-term securities. They know that the price at which they sell or buy will be
fair, and that they could easily sell those securities to someone else before maturity
(again, at a fair price).

An efficient market is important to financial executives because they use the market
value of the stock to measure managerial performance. Corporate actions that
maximize the market value of the stock are only meaningful if the market value
indicates that the firm is managed well and has made the best decisions.

Financial executives also need to know they can raise capital by issuing securities
and repurchase shares at fair prices.

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Corporate Finance Week 1— Practice Problem Solutions

b)
i. This violates the weak form of market efficiency. It is the weak form because it
deals only with historical market data. The hypothesis is violated because the
loser portfolio is providing better returns for the current period than the winner
portfolio. However, if the market is weak-form efficient, historical market data
cannot be used to develop a strategy to earn returns in the current period; these
data should already be impounded in price.
ii. This violates the semi-strong form of market efficiency. The information being
used is publicly available. Under the semi-strong form of market efficiency, the
price should already impound this information and as such, it can not be used to
earn higher returns, most certainly not over a long period.

Source: Topic 1.2-1

Solution to Practice Problem 10

a) In finance, it matters when a dollar is received or disbursed. One dollar you receive
today is worth more than one dollar you receive a year from now because you can
earn a return over the year on the dollar you receive today.

To compare dollars, you must standardize them to the same point in time.
Standardizing future dollars to current dollars is called discounting, while expressing
dollars in terms of a future date is called compounding.

b) For the second option, you can use a financial calculator to find out the present
value of the payments.

The timeline for option (ii) looks as follows:

Time - Year
0 1 2 3 4 5 6 7 8 9 10

$160,000 $160,000 $160,000 $160,000 $160,000 $160,000 $160,000 $160,000 $160,000 $160,000

The answer is $983,131.

N = 10 years
I/Y = 10% per year
PMT = –$160,000
CPT PV = $983,131

The first option, the immediate payment of $1,000,000, is best.

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Corporate Finance Week 1— Practice Problem Solutions

You could also compare the future values at the end of the 10-year period. This will
always lead to the same conclusion.

For the cash prize (the first option):

FV = 1,000,000 (1.10)10 = $2,593,742

For the annual payments (the second option):

N = 10 years
I/Y = 10% per year
PMT = –$160,000 per year
CPT FV = $2,549,988, which is $43,754 less than the first option

Source: Topic 1.5

Solution to Practice Problem 11: Multiple-choice question

Option c) is correct. The timeline of the payments looks as follows:

Time - Month
0 1 2 3 4 5 ….......... 40

$2,000 ?? ?? ?? ?? ?? ??

Using the financial calculator:

N = 40 monthly payments
I/Y = 24%/12 = 2% per month
PV = $10,000
CPT PMT = –$365.56 per month

Option a) is incorrect. It ignores discounting.

Option b) is incorrect. It treats the stated 24% annual rate as an effective rate rather
than a nominal (stated) annual rate.

Option d) is incorrect. It ignores the $2,000 down payment.

Source: Topic 1.5

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Corporate Finance Week 1— Practice Problem Solutions

Solution to Practice Problem 12: Multiple-choice question

Option b) is correct.

Option a) is incorrect. It describes a security provision.

Option c) is incorrect. It describes a sinking fund provision.

Option d) is incorrect. It describes a call provision.

Source: Topic 1.3-2

Solution to Practice Problem 13

Timeline for the $5,000 monthly annuity to infinity:
Time - Month
0 1 2 3 4 5 ….......... Infinity

$5,000 $5,000 $5,000 $5,000 $5,000 $5,000

Timeline for $6,000 per month for 20 years (240 months):

Time - Month
0 1 2 3 4 5 ….......... 240

$6,000 $6,000 $6,000 $6,000 $6,000 $6,000

First determine the PV of the 20-year annuity:

N = 20 × 12 = 240 months
I/Y = 7/12 = 0.5833% per month
PMT = $6,000 per month
CPT PV = –$773,919

Then determine the length of time required for the $5,000 payment to yield a PV equal
to that for the 20-year annuity:
PV = –$773,919
PMT = $5,000 per month
I/Y = 0.5833 per month
CPT N = 400.94 months or 33.41 years

Source: Topic 1.5-2

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Corporate Finance Week 1— Practice Problem Solutions

Solution to Practice Problem 14

CPA Way step: Assess the Situation

As an investment analyst, using non-traditional data may provide an advantage in

predicting share price movements before peers in the industry. Therefore, there are
benefits of using this data. However, there are several risks associated with this data
that need to be addressed and further investigated. For my analysis, there are two
major areas of concern:
1. Implications and concerns about using the data to help RHG analyze BCI and
forecast volumes of patients to forecast sales
2. Implications and concerns about using the data to predict share price movements
for FXG

Each of these situations is addressed separately below:

1. Implications and concerns about using the data for BCI assessment

CPA Way step: Assess the Situation

The use of the information on patient volumes will help to forecast revenues that
might be achieved by BCI once its drugs are marketed. Detailed patient volumes will
ensure that the forecasts are more plausible and realistic. With this more detailed
information, the forecasts for the share prices can be better predicted. This is the
benefit to using this data.

CPA Way step: Analyze Major Issue(s)

The following are areas of concern and implications:

• What is the origin of the data and how was it gathered? RHG purchased the data
specifically for the purpose of forecasting patient volumes. The data broker sells
this data for just this reason. The data has been provided by a variety of
healthcare professionals, and they have given their permission for this specific
use.
• It appears that the data broker has the right to sell this data for these specific
uses. Therefore, RHG appears to be within its legal rights to use this data to
predict patient volumes.
• Was the data gathered originally on an anonymous basis or was it made
anonymous afterwards by deleting personal information? It appears that the data
was gathered initially with personal information attached; otherwise, Janis would
not have been able to identify the patients. However, for making the BCI

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Corporate Finance Week 1— Practice Problem Solutions

predictions, the personal information is not necessary or required. Therefore, this

data can still be used without the personal information being attached.
• As the information is being used at an overall level instead of a personal level,
there are likely no ethical issues about using the data to predict patient volumes.
• Is the data accurate and valid? There is a risk that the data is not accurate or
valid for RHG’s purposes. However, this data is sold and used by various
government agencies and other healthcare agencies, so it is likely that the data
is accurate and useful for predicting patient volumes.
• One remaining issue is that Janis was able to identify the personal information.
Why is that? Whose responsibility is it to ensure the data is completely
anonymous? The data broker should be informed of this issue immediately.
• Because data security has become a major legal issue, this situation should be
discussed with a lawyer to determine if the breach of basic data security should
be reported to law enforcement.

CPA Way step: Conclude and Advise

Therefore, assuming the personal information can be deleted and only the
anonymous data is used to predict patient volumes, the data can be used legally and
ethically. However, it is important that RHG inform the data broker immediately so
that it can take appropriate action to ensure the personal information is deleted.

2. Implications and concerns about using the data to predict share price
movements for FXG

CPA Way step: Assess the Situation

For the second issue, there are significant ethical and legal implications. RHG will
certainly have an advantage if it uses the information to make share price
predictions.

CPA Way step: Analyze Major Issue(s)

However, significant risks are associated with using this data, as follows:
• Clearly, this is private and personal information about Steven Russell that has
not been made public. It is also unlikely that Steven gave his permission to
release his personal information. Therefore, even though RHG has access to the
data, using it would be unethical.
• A second consideration is the validity and accuracy of the information. How can
RHG know that the data relates to Steven Russell of FXG? The identification
process may have caused errors in any of the identifying information.
• It is likely illegal to use this personal information because it was not part of what
RHG actually purchased and was not intended to be used for RHG’s purposes.

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Corporate Finance Week 1— Practice Problem Solutions

CPA Way step: Conclude and Advise

RHG should not use this personal information on Steven Russell to make share
price predictions for FXG. After discussions with the lawyer on the legal ramifications
of this breach of privacy, RHG will have a better idea of how to handle this situation.
In the meantime, Janis should ensure that all the personal information is kept
somewhere very secure. It will likely need to be deleted, and Janis will need to
ensure that the deletion is permanent.

Source: Topic 1.2-3

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