AMERICAN UNIVERSITY IN BULGARIA BUS 306: CORPORATE FINANCE I SPRING 2011, AUBG

MIDTERM EXAM 1 Name: ___________________________________ ID _________ Version 2 Solution Guide

INSTRUCTIONS: 1. You have 90 minutes to complete the exam. 2. The exam is worth a total of 100 points. 3. You may use a calculator and scratch paper sheets. You must hand in the sheets with your exam (put your name on it). 4. Allocate your time wisely. Use the number of points assigned to each problem as your guide. 5. In order to get full credit on the problems, you must show ALL your work! 6. You can get partial credits if you show your calculations or provide arguments to support your answer. 7. No credits will be warded if you fail to state your assumptions or conclusions explicitly.

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The cash flows for an annuity due must all occur at the ends of the periods. but it does not reflect the effects of buying or selling fixed assets. The statement of cash flows reflects cash flows from operations. and short-term liquid securities (or cash equivalents) increased or decreased during a given year. A sharp increase in its forecasted sales and a corresponding increase in its total assets. c. The statement of cash flows reflects cash flows from operations and from borrowings. The cash flows for an annuity must all be equal. Corporations generally are subject to fewer regulations and more favorable tax treatment than sole proprietorships and partnerships. Which of the following statements is CORRECT? a. then the series is by definition an annuity. e. b. it provides a listing of all banks and brokerage houses where cash is on deposit. net 90. One advantage of the corporate form of organization is that liability of the owners of the firm is limited to their investment in the firm. This is why corporations do most of the business in the United States. e. Managers who face the threat of hostile takeovers are less likely to pursue policies that maximize shareholder value than are managers who do not face the threat of hostile takeovers. The company discovers that it has excess capacity in its fixed assets. such as once a year. it is easier for sole proprietorships and partnerships to raise large amounts of outside capital than it is for corporations. Which of the following statements is CORRECT? a. and they must occur at regular intervals. Answer: E 4. The statement of cash flows shows where the firm’s cash is located. b. bank deposits. c. The statement of cash flows reflects cash flows from continuing operations. e. d.the total of currency. d.5 points each. e. The company reduces its dividend payout ratio. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)? a. If some cash flows occur at the beginning of the periods while others occur at the ends. Jefferson City Computers has developed a forecasting model to estimate its AFN for the upcoming year. then we have what the textbook defines as a variable annuity. b. c. net 35. from a supplier whose terms are 3/15. 2 . d. Which of the following statements is CORRECT? a. Because of their simplified organization. The company switches its materials purchases to a supplier that sells on terms of 1/5. Answer: C 2. If a series of unequal cash flows occurs at regular intervals.Part A: Multiple choice questions (2. b. but it does not reflect cash obtained by selling new common stock. c. 15 points in total): 1. Answer: D 3. Bond covenants are an effective way to resolve conflicts between shareholders and managers. All else being equal. indeed. The statement of cash flows shows how much the firm’s cash . such as once a year or once a month. but it does not reflect the effects of changes in working capital. A switch to a just-in-time inventory system and outsourcing production. d.

d. Inflation fluctuates significantly. b. Other things held constant. the lower its required rate of return Answer: A 3 . A stock’s dividend yield can never exceed its expected growth rate. Answer: C 6. Market interest rates decline sharply. If the stock’s dividend is growing at a constant rate of 5%. e. c. Market interest rates rise sharply.Answer: A 5. Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds? a. Which of the following statements is CORRECT. the higher a company’s beta coefficient. assuming stocks are in equilibrium? a. Assume that the required return on a given stock is 13%. c. The company’s bonds are downgraded. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield. A required condition for one to use the constant growth model is that the stock’s expected growth rate exceeds its required rate of return. The company's financial situation deteriorates significantly. e. b. its expected dividend yield is 5% as well. d.

Solution: EFN = (A0*/S0)∆S – (L0*/S0)∆S – (PM)(S1)(1 – payout rate) =  0. thus increasing its cash flow: ∆CF = T(∆Depreciation) = 0.000.000 .3) = $600. Thus. and depreciation is expected to be $1.000 – $90. Set up an income statement. and the forecasted payout ratio is 70%. If depreciation doubled.Use the EFN equation to forecast Tandem 's additional funds needed for the coming year.000 = $410.000   $1. taxable income would fall to zero and taxes would be zero.000) – ($300.000. current liabilities were $1 million.4($1. (8 points) Tandem Video Product’s sales are expected to increase by 20% from $5 million in 2010 to $6 million in 2011.000 of notes payable.05($6.000.000 Depreciation 1. All sales revenues will be collected in cash. but net cash flow would rise to $3.400.5 million.000. $500. net income would decrease to zero.000 Net income $ 900.000 of accounts payable.000 EBT $ 1.000 b. What is Talley’s expected net cash flow? b.7) = (0.500.000 .000) = $600. (8 points) The Talley Corporation expects to have sales of $12 million. Suppose Congress changed the tax laws so that Talley’s depreciation expenses doubled.6)($1. so its assets must grow at the same rate as projected sales. consisting of $250. Talley’s federal-plus-state tax rate is 40%.000.000)(1 –  $5. Costs other than depreciation are expected to be 75% of sales.000 Add back depreciation 1. Talley would save $600.000 –   $1.000.000   $5.500. What would happen to reported profit and to net cash flow? Solution: a. At the end of 2010.000 Net cash flow $ 2. Tandem Video is already at full capacity.Part B: Simple problems (8 points each. No changes in operations occurred.000.000  4 .000   $500 .500.000 Costs except depreciation 9.000 . 32 in total) 7. a.000.000 – 0. Income Statement Sales revenues $12.000)(0.500.000 of accruals. Its assets totaled $3 million at the end of 2010.  $3. The after tax profit margin is forecasted to be 5%.000 Taxes (40%) 600. 8. and costs other than depreciation must be paid for during the year.1)($1.000 in taxes. Berndt has no debt.000) – (0.000. and $250.000.000.000 – $100.

The price of the bond will decline toward $1. c.6%.050/share. FV = 1. and you expect to sell it at a price of $26. Calculator solution: Change inputs from Part (a) to I/YR = 6. Calculate the expected dividend yield for the same year. b.050 – 1 = 5. a $1000 par value. Calculator solution: I/YR = ? I = 5. The bonds now have an 8-year.2250 in Year 1. and semi annual interest payments. Dividend Yield = D1/P0 = $1.1449. g = $1.000. c. 2 years after the bonds were issued. PV = -1. a. a. a 10% coupon rate. Suppose.94. Two years after the bonds were issued. or a 16-semiannual period.22 at the end of the year 3. (8 points) Suppose Wilsen Product Manufacturing sold an issue of bonds with a 10-year maturity.22.1070.107/$21.43% = 10. the going interest rate had risen to 12%.17% + 5. c. hitting $1. Calculate the growth rate in dividends for the first year. FV = 1000. which pays a dividend of $1.1070/1.050. PV = ? PV = $1. what is this stock’s expected total rate of return? Solution: a. (8 points) You buy a share of MIT Corporation stock for $21.1070. At what price would the bond sell? (Note: two years have already passed) b. and 1. Assuming that the calculated growth rate is expected to continue. What would happen to the price of the bond over time? Solution: a.251.40 = 5.000 (plus accrued interest) at the maturity date 8 years (16 six-month periods) hence. At what price would the bond sell? (Note: two years have already passed) c. 2 and 3 respectively. b. Suppose that. maturity. PMT = 0.9.43%. $1. as in part (a) that the interest rates fell to 6% two years after the issue date and they had remained at 6% for the next 8 years (until maturity). PV = ? PV = $898.17%. Input N = 1. ∧ r s= D1/P0 + g = 5. 5 . b. I/YR = 3. and their value is calculated as follows: Calculator solution: Input N = 16. PMT = 50.40.43%. You expect it to pay dividends of $1. the going rate of interest on bonds such as these fell to 6%. 10.

80 Assets Balance sheet $111.734. A dividend of $963.00 Taxes (34%) $1.380. What external financing is needed? (Note: Note: construct the pro-forma balance sheet to find EFN).890.32 Addition to retained earnings = $1.0 0 1.040. Solution: An increase of sales to $23.400 $72. Next year’s sales are projected to be $23.200 Sales increase = .734.040 – 19.0 0 Cost $18. are shown below: Income Statement Sales $19.40.409 Assets Total Balance sheet $93.334.600 + 1. 39 in total) 11.48 = $74.156.48 And the new equity balance is: Equity = $72.0 0 Taxable income $4.890.0 0 $72.4 8 The payout ratio is constant. (13 points) The most recent financial statements for Maritin. Problem solving (13 points each.156.200) / $19.650 Taxes (34%) $1.20 or 20% Assuming costs and assets increase proportionally.200 Cost $15.734.241 Net income $2.040 is an increase of: Sales increase = ($23.600.000 Assets and costs are changing proportionally to sales.600 – 94.040.600 $93.48 = $16.48 So the EFN is: EFN = Total assets – Total liabilities and equity EFN = $111. Debt and common equity do not change.40($2.80) Dividends = $1. so the dividends paid this year is the payout ratio from last year times net income.660. the pro forma financial statements will look like this: Income Statement Sales $23.32 Addition to retained earnings = $2.52 6 .600 Total $20.000 Debt Equity $93.600 Debt Equit y Additions to RE Total $111.000 Total $20.60 was paid and Maritin wishes to maintain a constant dividend payout ratio of 0.550 Taxable income $3.734.890.20 Net income $2. or: Dividends = 0.489.80 – 1.865.48 $94. Inc.400.734.C.

0816 Step 3: Calculate the PV of the expected dividends: PVDiv = $2.88 + 58. What is your estimate of the stock’s current price? What is the stock price in one year if it appreciates with the same rate as dividends? Solution: Step 1: Calculate the required rate of return on the stock: Rs = RRF + b(RrM .RRF) = 7.28 = $4.5%. A and B.52. that is. Calculate the coefficient of variation for each stock.5% – 7.08 = $50.00(1.00 D1 = $2. Return on stock A (%) 6. Step 6: Sum the PVs to obtain the stock’s price: ˆ P0 = $4.20) = $60.99 (2. which are equally likely to happen.14 + $2.3%.07) = $58. Step 4: Calculate P2 : ˆ P2 = D3/(Rs – g) = $3. The company’s stock has a beta of 1.2 = 12.143.14). and the market return is 11.42.5%)1.00(1.12.6 Return on stock B (%) -3. using a financial calculator.20) = $2. (13 points) A company currently pays a dividend of $2 per share. ˆ Step 5: Calculate the PV of P2 : 2 PV = $58.3% 10.52(1 + 0. (13 points) Suppose you have invested only in two stocks.88/(1.42 + $46.5% + (11.88(1.123) + $2.88 D3 = $2.123 – 0.123)2 = $2. I/YR = 12. the risk-free rate is 7. D0 = $2. Calculate the standard deviation of returns of each stock using equal probabilities of occurrence. P1 = P0(1 + g) = $50.3 Calculate the expected return of each stock using equal probabilities of occurrence. to be as follows: State of the economy Bear Normal Bull a.7% 6.07) = $3.5%. c. Alternatively. and CF2 = 60.4 25.2. b. You expect that returns on the following three states of the economy.10.20)2 = $2. then at a constant rate of 7% thereafter.50.123) = $46. Which stock is riskier? 7 .0816/(0. CF1 = 2.14/(1.3 and solve for NPV = $50.40.40/(1. Step 2: Calculate the expected dividends: D0 = $2.5 15.624 13.4 D2 = $2. It is estimated that the company’s dividend will grow at a rate of 20% per year for the next 2 years. input the following: CF0 = 0.

or 12.014447 Standard deviation σ B = 0.108)^2]/3 = 0.352 Coefficient of variation (B) = 0. Expected return A = (6.3%)/3 = 9.0014459 Standard deviation σ A = 0.3% + 10.108)^2 + (0.3% b.093)^2 + (0.093)^2]/3 = 0.037 – 0. Variance σ A2 = [(0.1080 = 0.8026% Variance σ B2 = [(-0.063 – 0.093 = 1.5% + 15.292 Stock B is riskier as it has higher standard deviation and coefficient of variation.4% + 25.038026/0.6%)/3 = 10.253 – 0.038026.Solution: a.0.120196.105 – 0.7% + 6.8% Expected return B = (-3.120196/0. Coefficient of variation (A) = 0.093)^2 + (0.156 – 0. 8 . or 3.0196% c.108)^2 + (0.064 – 0.

Part D: Essay question (10 points in total) List the three forms of market efficiency according to the EMH and give examples for each of them Extract from an excellent student’s answer: 9 .

2. Political Anthropology c. 10 . Corporate finance 1 and 2 b. Introduction to Music d.Part D: Bonus questions (2 points each. Lucia Miree b. Which of the following classes use case-based learning approach? a. 4 in total) 1. Donald Brady c. Who is the current chair of the Business Department? a. Steve Sullivan d. Beginning Drawing Answer A. Cy Reed Answer B.

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