Corporate Finance

Week 1
Practice Problems

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2020-07-16
Corporate Finance Week 1 — Practice Problems

WEEK 1 — PRACTICE PROBLEMS

Practice Problem 1: Multiple-choice question (2 minutes)

Northern Telecom has announced the earnings surprise that its quarterly earnings will
be less than the market’s expectations. If the markets are informationally efficient, what
will be the likely response in the stock’s price?

a) The stock price will drop sharply, overcorrect, and then recover slightly.
b) The stock price will gradually decline to the new fair price.
c) The stock price will immediately decline to the new fair price.
d) The stock will not likely be significantly impacted.

Practice Problem 2 (Easy — 5 minutes)

The financial executive has three primary functions or roles to perform in the
management of a company. Briefly describe these three functions, and then explain the
financial executive’s primary goal.

Practice Problem 3 (Easy — 5 minutes)

Financial markets don’t exclusively focus on the exchange of existing securities. What
are the other roles of the financial markets?

Practice Problem 4 (Easy — 5 minutes)

You purchased shares of a company in the automotive industry a year ago. Over the
last year, the economy began to slow down and the company faced declining sales. As
a result, the stock price declined over your holding period. Explain whether or not the
behaviour of the stock price over the holding period is consistent with informational
efficiency. If it is, which form of efficiency is it consistent with?

Practice Problem 5 (Average — 15 minutes)

Hammersmith Inc. (HI), a publicly traded company, is looking to raise some new capital
for an investment in equipment. Currently, HI has a debt-to-equity ratio of 1.5 and a loan
covenant that requires HI’s debt-to-equity ratio to be less than 1.8. In addition, the
industry has just entered a downturn, and HI is concerned that its revenues for next
year will be lower than originally forecast. HI is considering two alternatives to raise this
new capital: to issue either bonds or preferred shares.

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Corporate Finance Week 1 — Practice Problems

Required:

Outline the basic similarities and differences between bonds and preferred shares.
Make a recommendation on the type of financing HI should issue at this time.

Practice Problem 6 (Average — 10 minutes)

a) Why do retractable and extendible bonds generally offer lower yields to maturity than
straight bonds with similar risk and maturity?
b) Why are corporations willing to pay higher coupons on callable bonds than on similar
non-callable bonds?

Practice Problem 7 (Easy — 5 minutes)

Briefly explain the concept of term structure as it relates to estimated required interest
rates for debt.

Practice Problem 8 (Easy — 10 minutes)

Answer the following unrelated questions about interest rates.

a) If the expected rate of inflation is 4% and the real rate of interest is 2.5%, calculate
the nominal interest rate.
b) If the nominal interest rate is 7% and the expected rate of inflation is 5%, calculate
the underlying real interest rate.
c) If the expected inflation increases by 1%, what will happen to both nominal and real
interest rates?

Practice Problem 9 (Difficult — 25 minutes)

For a securities market to function smoothly, it must be informationally efficient.

Required:
a) Explain why it is important to investors and to financial executives that capital
markets be informationally efficient.
b) What is the highest of the three forms of market efficiency that applies in each of the
following investment scenarios? State whether the scenario supports or violates that
form of efficiency and explain why.

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Corporate Finance Week 1 — Practice Problems

i. Contrarian strategies: Stocks are classified as winners or losers based on their

total returns over the past three to five years. The returns on the loser portfolio
are substantially better than the returns on the winner portfolio in the current
period.
ii. Value investing: An investor identifies stocks with below-average price-to-
earnings (P/E) and market-to-book (M/B) ratios and above-average dividend
yields. The returns on these stocks are significantly higher than the returns on
growth stocks over long periods of time.

Practice Problem 10 (Average — 10 minutes)

a) Briefly explain why cash flows (dollars) can only be talked about in relation to when
they are received or paid out and explain how dollars received at different points in
time can be compared.
b) Your friend has called you with some exciting news — she has won a lottery prize.
However, she must choose one of the following prize options:
i. an immediate cash prize of $1,000,000
ii. annual payments of $160,000 at the end of each of the next 10 years

Assuming an annual interest rate of 10%, calculate the present value of the
$160,000 annual payments. Which option has the higher value?

Practice Problem 11: Multiple-choice question (2 minutes)

Warren has just purchased a motorboat for $12,000, making a $2,000 down payment
and borrowing the balance from the Goodfriend Loan Co. at a stated interest rate of
24%. The loan must be repaid in 40 equal monthly instalments at the end of each
month. What is the required monthly payment?

a) $250.00
b) $353.41
c) $365.56
d) $438.67

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Corporate Finance Week 1 — Practice Problems

Practice Problem 12: Multiple-choice question (2 minutes)

Which of the following statements about a retractable bond is true?

a) A retractable bond is a bond that offers the holder a right to a particular asset of the
borrower if the borrower defaults.
b) A retractable bond is a bond where the holder can sell back the bond to the borrower
at some date prior to the bond’s maturity.
c) A retractable bond is a bond where the borrower must gradually retire the bond by
buying back a part of the bond issue from the holder each year.
d) A retractable bond is a bond where the borrower can buy back the bond from the
holder at some date prior to the bond’s maturity.

Practice Problem 13 (Difficult — 25 minutes)

Your father has recently retired and is considering two annuity options offered by his life
insurance company: (Note: both options pay at the end of the month.)

a) Purchase a life annuity that pays him $5,000 per month for as long as he lives.
b) Purchase a 20-year annuity paying $6,000 per month (only for 20 years and
payments will continue to his estate if he dies before 20 years).

Assuming a nominal or quoted interest rate of 7% per year that compounds monthly,
how long must your father live in order to make the first option a better deal?

Practice Problem 14 (Difficult — 25 minutes)

You currently work for RHG Investments Inc. (RHG) as an investment analyst following
companies in the healthcare industry. One of the companies that you follow, Best Cures
Inc. (BCI), is a pharmaceutical research company. You recently purchased access to a
healthcare database from a data broker that has data on patients being treated. This
data has been provided with authorization from many healthcare professionals and is
allowed to be used for predicting patient volumes and healthcare costs. Government
agencies and other healthcare stakeholders use this information and have done so for
many years. You intend to mine this data to forecast the volume of patients who might
be treated with the four new drugs that BCI is developing. The drugs have just been
given regulatory approval and will be available for sale within the next 12 months.

You had asked your IT assistant, Janis, to run a variety of programs on this data to
narrow down the information to what you need. Janis has just met with you and given
you a summary of what she was able to do.

By running the programs, Janis has been able to extract not only the volume of patients
you need, but also information on age, gender, and address. Janis was also able to
identify personal information linked to each patient, including the name of the patient,
the length of time they have had the disease, and the potential for recovery.

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Corporate Finance Week 1 — Practice Problems

Janis is very excited about this development, since she has recognized some of the
names. In particular, she recognized Steven Russell, a key researcher at another
pharmaceutical research company that you follow called FXG Inc. Steven is key to the
success of FXG, and you believe the company will not be able to complete its research
and bring its drugs to market without his knowledge and expertise. You also know that
there is no one else at FXG who could take on Steven’s role without negative
repercussions. By using this data, you predict that FXG’s share price will fall significantly
once the news becomes known.

You have concerns about using the data and have had a brief discussion with your
supervisor. He has asked for a report outlining your concerns about this data and the
implications of using it.

Required:

Discuss the implications and concerns you have about this data, in particular:
a) From the perspective of using the data to help you analyze BCI and forecast future
share price movements. Draw a conclusion as to whether you should use the data
for this purpose.
b) From the perspective of using the data to predict share price movements for FXG.
Draw a conclusion as to whether you should use the data for this purpose.

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