CORPORATE FINANCE EXAM REVISION ANSWERS

P10-2 Payback comparisons (LG 2; Intermediate)

a. IntelWash: $25,000 ÷ $6,500 3.85 years. KwikWash: $75,000 ÷
$9,500 7.89 years.
b. The maximum acceptably payback period is 5 years. Only IntelWash has a faster
payback, and Soviet Services should accept only that project.
c. The firm will accept IntelWash because the payback period of 3.85 years is less
than the 5-year maximum payback required by Soviet Services.

P10-10 NPV: Mutually exclusive projects (LG 3; Intermediate)

a.,b., c, d and e.
Cash flows in thousands. Negative numbers are outflows; positive inflows.
Profitability Index = Present value of cash inflows Initial outlay (expressed as
positive number).
Robotic Line A Robotic Line B Robotic Line C
Year Cash Flows Cash Flows Cash Flows
0 € (850) € (600) € (1,500)
1 € 150 € 120 € 800
2 € 150 € 140 € 300
3 € 150 € 160 € 200
4 € 150 € 180 € 200
5 € 150 € 200 € 200
6 € 150 € 250 € 300
7 € 150 € 400
8 € 150 € 500
NPV = €(176.237) NPV = €121.135 NPV = €449.196
REJECT ACCEPT ACCEPT
NPV rank = 3 NPV rank = 2 NPV rank = 1
PV of inflows 804,762.7 PV of inflows 721,135.4 PV of inflows 1,949,196.0
Profitability Profitability Profitability
index = 0.95 index = 1.20 index = 1.30
PI rank = 3 PI rank = 2 PI rank = 1

Calculating the required rate of return (LG 6)

Answer: The CAPM equation can be used to find required return, given an
asset’s beta, the risk-free rate, and market return. Specifically:
rj = RF + éë b j ´ ( rm - RF )ùû

where:
rj = required return on asset j j = Beta coefficient for asset j

RF = risk-free rate rm = Expected return on market

portfolio of assets
a. Required return = 0.05 + 1.8 (0.10 - 0.05) = 0.05 + 0.09 = 0.14.
b. Required return = 0.05 + 1.8 (0.13 - 0.05) = 0.05 + 0.144 = 0.194.
c. The risk-free rate does not change, but market return increases. The
resulting rise in the market-risk premium will cause the Security
Market Line (SML) to rotate counterclockwise about the fixed risk-
free rate..
9-3 Capital structure is the mix of debt and equity the firm employs. It represents the
cumulative long-term financing decisions the firm has made over time.

8-3 a. Risk-averse investors dislike risk and, therefore, expect higher returns on
riskier investments.
b. Risk-neutral investors select investments based on expected return—the
higher the better—without regard to risk. Such investors require no
compensation for bearing more risk.
c. Risk-seekers like risk. Just as risk-averse investors will give up some return to
avoid some risk, risk-seeking investors will give up some return to take more
risk.
Most financial managers are risk averse—they expect compensation for bearing
additional risk. Risk tolerance refers an investor’s degree of risk aversion, that is
the specific compensation she requires for taking additional risk. Two investors
may both refuse to accept more risk unless awarded a higher expected return—
that is, both are risk averse. But the more risk tolerant of the two will require less
additional compensation.

8-8 An efficient portfolio offers the maximum return for a given risk level. Portfolio
return is just the weighted average of returns on individual assets in the portfolio.
Specifically:

rsp = (w1 r1) + (w2 r2) + … + (wn rn) =

where:
rsp = portfolio return rj = the return on asset j

wj = the portfolio weight of asset j ( = 1) n = number of assets in

the portfolio
The standard deviation of a portfolio is not the weighted average of the standard
deviations of component assets. Rather, it is calculated with the standard-deviation
formula, using portfolio returns for various time periods (rather than returns on
individual assets in the portfolio) and the average portfolio return over those time
periods. Specifically:

σrp = where: σrp = standard deviation of portfolio returns

8-9 The correlation between asset returns is key to evaluating the effect of a new asset
on portfolio risk. Returns on different assets that move in the same direction are
positively correlated, while those moving in opposite directions are negatively
correlated. Unless the returns on assets in a portfolio are perfectly positively
correlated, portfolio standard deviation will be less than the weighted average of
the standard deviations of portfolio assets. If the absolute value of correlation
between assets in the portfolio is sufficiently low—it need not be negative—
portfolio standard deviation may be less than the standard deviation of the least
volatile portfolio asset. In short, the magic of diversification is that portfolio
returns can be less volatile than the returns on any single portfolio asset.

8-10 Adding foreign assets to a domestic portfolio can reduce risk for the same reason a
portfolio of two domestic assets can have less risk than one asset: returns on
foreign investments are not perfectly correlated with returns on U.S. investments,
so an internationally diversified portfolio generally has a lower standard deviation
of returns (less risk) than a purely domestic portfolio. That said, under some
circumstances, international diversification can produce subpar returns. For
example, when the dollar appreciates relative to other currencies, the dollar value
of foreign-currency-denominated portfolios declines, thereby producing lower
dollar returns. If the appreciation is traceable to a strong U.S. economy, foreign-
currency-denominated portfolios will generally have lower returns in local
currency as well, further reducing returns. Political risk—the risk political
instability or hostile governments could endanger foreign assets or profits—is
another potential pitfall of international diversification, particularly when
investing in developing countries.

8-11 The total risk of a security is measured by the standard deviation of returns; it has
two components –nondiversifiable risk and diversifiable risk. Diversifiable risk
refers to the portion of risk attributable to firm-specific, random events (such as
strikes, litigation, and loss of key contracts) that can be eliminated by
diversification. Nondiversifiable risk, in contrast, is attributable to market factors
affecting all firms at the same time (such as war, inflation, and political events).
Nondiversifiable risk is the only relevant risk because diversifiable risk can be
 easily eliminated by forming a portfolio of assets with less than perfect positive
correlation. Because investors can easily eliminate this risk, the market will not
offer compensation in the form of higher returns to those who bear it.

8-12 Beta measures the nondiversifiable risk of a specific asset or portfolio; it is an

index of the co-movement of an asset’s return with the market return. The beta
coefficient for an asset can be found by plotting the asset’s historical returns
relative to the returns for the market and using statistical techniques to fit the
“characteristic line” to the data points. The slope of this line is beta. Beta
coefficients for actively traded stocks are widely published in print and online.
The beta of a portfolio is simply the weighted average of the betas of component
assets.

8-13 The capital asset pricing model (CAPM) is given by:

rj = RF + [βj ´ (rm - RF)]
where:
rj = required (or expected) return on asset j
RF = rate of return required on a risk-free security (U.S. Treasury bill)
βj = beta coefficient or index of nondiversifiable (relevant) risk for asset j
rm = required return on market portfolio of assets (market return)
The security market line (SML) is a pictorial presentation of the relationship
between an asset’s systematic risk and the required return. Systematic risk—
measured by beta—is on the horizontal axis while required return is on the vertical
axis.

8-14 a. An increase in inflationary expectations shifts the SML upwards by an amount

equal to the increase. The shift is parallel—that is, SML slope remains the
same—because the only change is that required return for a given level of risk
rose to reflect the higher expected inflation rate.
b. If investors become less risk averse, the slope of the SML (beta coefficient)
will decline—that is the SML will rotate clockwise around the given fixed
risk-free rate because a lower return is now required for each level of risk.

P8-2 Return calculations (LG 1; Basic)

Total return on an investment is given by:
 (Pt - Pt-1 + Ct )
rt =
Pt-1
where: rt = total return on asset Pt = Price of asset at time t-1
Pt = Price of asset at time t Ct = Cash received between t-1
and t
Investment Calculation rt (%)
A ($20,100 − $23,400 − $2,800) ÷ $23,400 –26.07
B ($324,000 − $225,000 + $16,000) ÷ $225,000 51.11
C ($8,000 − $6,500 + $700) ÷ $6,500 33.85
D ($46,500 − $36,600 + $3,580) ÷ $36,600 36.83
E ($52,800 − $62,700 + $500) ÷ $62,700 –16.59

P11-18 Incremental operating cash flows: Expense reduction (LG 5; Intermediate)

Year (1) (2) (3) (4) (5)
Incremental
expense ₹2,000,00 ₹2,000,00 ₹2,000,00 ₹2,000,00 ₹2,000,00
savings 0 0 0 0 0
Incremental
profits
before dep. 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000
and taxes*
Depreciation** 1,600,000 960,000 576,000 346,000 207,000
*
Net profits
before taxes 400,000 1,040,000 1,424,000 1,654,000 1,793,000
Taxes 120,000 312,000 427,200 496200 537,900
Net profits
after taxes 280,000 728,000 996,800 1,157,800 1,255,100
Operating cash
inflows** 1880,000 1,688,000 1,572,800 1,503,800 1,462,100
*Incremental profits before depreciation and taxes will increase the same amount as the
decrease in expenses.
**Net profits after taxes plus depreciation expense.
*** Reducing balance depreciation for each year is calculated according to the following
table:
 With a 21% tax rate, the lower half of the table would be:
Year Calculation of Yearly Depreciation Book Value
Year 1 (5,000,000 – 1,000,000) ´ 0.4 = 1,600,000 3,400,000
Year 2 (3,400,000 – 1,000,000) ´ 0.4 = 960,000 2,440,000
Year 3 (2,440,000 – 1,000,000) ´ 0.4 = 576,000 1,864,000
Year 4 (1,864,000 – 1,000,000) ´ 0.4 = 345,600 1,518,400
Year 5 (1,518,000 – 1,000,000) ´ 0.4 = 207,360 1,311,040

P13-6 Breakeven point: Changing costs/revenues (LG 1; Intermediate)

Let QBE = breakeven level of unit sales, FC = fixed cost, P = price, and VC =
variable cost per unit.
a. QBE = FC ÷ (P - VC) = €1,050,000 ÷ (€350 - €200) = 7,000 rugs
b. QBE = €1,300,000 ÷ (€350 - €200) = 8,667 rugs
c. QBE = €1,050,000 ÷ (€320 - €200) = 8,750 rugs
d. QBE = €1,050,000 ÷ (€350 - €220) = 8,077 rugs
e. The breakeven level of unit sales is directly related to fixed and variable
costs and inversely related to selling price.