CGACANADA
ADVANCED CORPORATE FINANCE [FN2] EXAMINATION
June 2011
Marks Time: 4 Hours
Notes:
1. Questions 1 and 2 are multiple choice. For these questions, select the best answer for each of the unrelated items. Answer each of these
items in your examination booklet by giving the number of your choice. For example, if the best answer for item (a) is (1), write (a)(1) in
your examination booklet. If more than one answer is given for an item, that item will not be marked. Incorrect answers will be marked as
zero. Marks will not be awarded for explanations.
2. Except for multiplechoice questions, answers should include all supporting calculations where appropriate.
3. If you provide alternative answers to Questions 3, 4, 5, or 6, only the first answer will be marked. If you wish to change your answer, you
must cross out the answer you do not wish to submit for marking.
12 Question 1
Note:
2 marks each
a. Which of the following is least likely to increase market efficiency?
1) Governments relax restrictions on foreign investment.
2) Corporations disseminate more information to investors.
3) More new investors choose to invest in individual stocks on their own rather than invest in mutual
funds.
4) More stock transactions are conducted online than on the floor of an exchange.
b. Which of the following is the best example of ethical behaviour?
1) ABC Corp. cut employees hours and pay without laying off anyone.
2) Instead of depleting its retained earnings, DEF Inc. borrowed heavily to expand.
3) JKL Ltd. used government bailout money to pay wages owed to its employees.
4) Executives at MBI Corp. shared their performance bonus with new employees.
c. Which of the following represents one of the classes for cash inflows and outflows relevant to a
capital budgeting decision?
1) Terminal cash flows
2) Sunk cost
3) Undepreciated capital allowance
4) Investment credit
d. Which of the following statements is true about the weighted average cost of capital (WACC)
method?
1) WACC can be used to evaluate projects in which the capital structure is significantly different
from the firms overall structure.
2) WACC is very efficient in evaluating the impact of special financing arrangements on projects
because it determines the cash flows that can be distributed to shareholders after paying operating
costs, financing costs, and debt repayments.
3) WACC explicitly calculates interest tax shields that are generated by debt securities for the
financing of a project.
4) WACC adjusts for the deductibility of interest costs.
Continued...
EFN2J11 CGACanada, 2011 Page 2 of 7
e. Which of the following statements is true about lease financing?
1) The term of a typical operating lease is almost equal to the useful life of the asset.
2) Leasing always provides the same tax breaks to the lessor and the lessee.
3) Operating leases can avoid the risk of obsolescence.
4) In a typical sale and leaseback arrangement, the asset is sold for its book value and is leased using
a capital lease.
f. Which of the following is the best alternative for a Canadian exporter that is expected to receive
US dollar payments?
1) Buy calls on US dollars
2) Buy puts on US dollars
3) Buy puts on Canadian dollars
4) Sell puts on US dollars
18 Question 2
Note:
3 marks each
a. BMINE Inc. has sales of $500,000 with a degree of operating leverage of 1.5. To increase earnings
before interest and taxes (EBIT) by 10% for this year, how much sales would it require?
1) $533,333
2) $550,000
3) $575,000
4) $750,000
b. What is the effective annual interest rate on a bank loan that charges 13% interest compounded
semiannually with a 9% compensating balance, with loan payments made semiannually?
1) 10.34%
2) 14.29%
3) 14.80%
4) 16.67%
c. To make a Canadian investor indifferent between investing in 1year Canadian dollar term deposits
and investing in 1year British pound term deposits, what should the 1year forward exchange rate of
the British pound be?
Annual rate on a 1year term deposit denominated in Canadian dollars 1.49%
Annual rate on a 1year term deposit denominated in British pounds 2.93%
Spot rate to buy 1 British pound C$1.5183
1) C$1.3492
2) C$1.4971
3) C$1.5398
4) C$1.7086
Continued...
EFN2J11 CGACanada, 2011 Page 3 of 7
d. MNO Corp. is considering either leasing or borrowing to purchase a machine costing $100,000 with a
5year life. If the machine is purchased, MNO will be responsible for the annual pretax maintenance
costs of $5,000. MNOs tax rate is 30% and it is able to borrow at a 10% interest rate. The CCA rate is
20% and the machine has no scrap value. Alternatively, a manufacturer offers to lease the machine to
MNO for a 5year term at $25,000 per year with the first lease payment due when the contract is
signed. What is the equivalent loan for this lease?
1) $ 43,083
2) $ 71,785
3) $ 86,073
4) $ 109,680
e. What is the average rate of return for a 5year project costing $250,000 and generating $50,000 in
annual cash flows in the first 2 years and $30,000 in the last 3 years?
1) 15.20%
2) 20.00%
3) 30.40%
4) 76.00%
f. LED Inc. is issuing rights to its shareholders of record as of the close of business on Thursday,
June 23, 2011. Each right entitles its holder to purchase 1 new share for $10.00. Just after the rights
offering announcement, LED shares were trading at $12.00 per share. Without any material market
wide or firmspecific event occurring after the rights offering announcement, what will the value of
1 LED share be on June 22, 2011?
1) $ 9.00
2) $10.00
3) $11.00
4) $12.00
EFN2J11 CGACanada, 2011 Page 4 of 7
15 Question 3
GiftsRUs Inc. (GRU) is an Ontariobased company with a national chain of gift shops. The business is
seasonal, with 50% of GRUs sales occurring during the months of October, November, and December.
Net working capital doubles throughout this high sales season. Credit sales are high, with only 25% of
customers paying in cash. Sales for the year are $10,000,000. The cost of goods sold is 75% of sales, and it
is not expected to change. The following is GRUs balance sheet at November 30, 2010.
EXHIBIT 31
GIFTSRUS INC.
Balance Sheet
November 30, 2010
Assets Liabilities
Current assets Current liabilities
Cash $ 150,000 Accounts payable $ 450,000
Accounts receivable 850,000 Accrued expenses 100,000
Inventory 1,200,000 Notes payable 170,000
2,200,000 Current portion of longterm debt 40,000
760,000
Longterm debt 1,400,000
Capital assets 2,000,000 Shareholders equity 2,040,000
Total assets $ 4,200,000 Total liabilities and shareholders equity $ 4,200,000
Required
2 a. Calculate the estimated seasonal portion of net working capital.
1 b. Indicate what policy GRU is following regarding the financing of its net working capital needs.
8 c. Calculate the cash conversion period and the operating cycle, and explain the significance of the cash
conversion period in general and in this particular case.
4 d. The local bank has quoted the following term structure of interest rates:
3 month 7.5%
1 year 7.0%
3 year 6.5%
5 year 6.0%
Identify the markets expectation for future interest rates. Discuss one disadvantage of the financing
policy that GRU is using. Recommend one alternative for GRU to avoid this disadvantage.
EFN2J11 CGACanada, 2011 Page 5 of 7
15 Question 4
BC Transport Inc. (BCT) is a British Columbiabased company providing transportation services to the
mining industry. It has 8 million common shares outstanding. The market value of its debt is $400 million
at an interest rate of 10%. BCT has a corporate tax rate of 40% and a levered beta of 1.8. The riskfree rate
is 5% and the stock market is expected to return 11%. BCT expects annual earnings before interest and
taxes (EBIT) of $70 million forever, and it pays out all the earnings as dividends to shareholders.
Observing that many companies with a high debt load have gone bankrupt during the recent financial
crisis, Al, BCTs CFO, is concerned with BCTs marketvaluebased high debttoasset ratio. He would
like to reduce BCTs debttoasset ratio to 40%, by issuing additional equity and paying off some debt.
Required
5 a. Calculate the current cost of equity, value of equity, price per share, total value of BCT, and its current
debttoasset ratio.
10 b. i) Calculate the total value of equity that BCT should issue to reduce the debttoasset ratio to 40%.
ii) Prove that the cost of equity decreases after BCT pays off some debt.
20 Question 5
Recent positive economic data indicates that the recession is over and that the Canadian economy will
soon enter a period of growth and prosperity. The recession made financially healthy firms stronger and
weak firms weaker. In order to profit from the upcoming economic growth, strong companies have begun
to expand their capacity. They are either building new plants or expanding their existing capacity by taking
over weaker competitors. ABL Corp. is one of the industry leaders looking for target companies to acquire
on the market. One such target, AIM Inc., is being pursued by ABLs main rival, LAB Inc. LAB has made
a bid valuing AIM at $100,000. Senior management are seeking your advice on whether ABL should also
bid on AIM.
You have projected AIMs free cash flows and estimated other information if it is acquired as follows:
Year
0 1 2 3 4 5
Free cash flows to the firm N/A $ 6,500 $ 6,950 $ 7,650 $ 8,050 $ 9,000
Outstanding longterm debt 52,500 50,000 47,500 45,000 42,500 40,000
Annual capital amortization 11,300 11,500 12,000 12,000 12,200 12,200
Net working capital 11,000 10,500 11,000 10,600 11,000 11,800
The current expected market return is 12%, and the longterm government bond rate is 6%. AIMs debt
pays 8% (effective) interest. Debt principal is repaid in equal amounts at the end of each fiscal year. Its
levered stock beta is 1.5. The corporate income tax rate for both ABL and AIM is 40%. ABL intends to
achieve a longterm debttoequity ratio for AIM of 40%, and plans to assume AIMs current longterm
debt.
Continued...
EFN2J11 CGACanada, 2011 Page 6 of 7
Required
3 a. Indicate what type of merger and acquisition this example is and identify two possible reasons for
ABL to acquire AIM.
3 b. Identify the appropriate discount rate(s) for the valuation of AIM based on free cash flows to the firm
(FCFF) using the APV method.
5 c. Determine AIMs value including and excluding the longterm debt based on FCFF using the APV
method (including debt and common shares only). Assume that debt interest applies to the
previousyear longterm debt, and that residual cash flows to the firm are expected to increase at a rate
of 3% per year. (Ignore any tax shield related to debt remaining after 5 years.)
1 d. Calculate the appropriate discount rate(s) for the valuation of AIM using the free cash flow to equity
(FCFE) method.
3 e. AIMs FCFE cash flows for 5 years are as follows:
Year
0 1 2 3 4 5
Free cash flows to equity N/A $1,480 $2,050 $2,870 $3,390 $4,460
Explain how these FCFE cash flows were calculated, using year 1 as an example. Show the
calculation for year 1.
5 f. Determine the value of the FCFE for AIM (including both debt and common shares only), assuming
that the residual cash flows to equity are expected to increase at a rate of 3% per year. Based on your
valuation, explain whether ABL should also bid on AIM against LAB.
EFN2J11 CGACanada, 2011 Page 7 of 7
20 Question 6
Bank of Manitoba (BM) is the banking division of a financial holding company. A schedule of the average
yields and costs on assets and liabilities of BM appears in Exhibit 61:
EXHIBIT 61
Average yields and costs on assets and liabilities of BM
Amount Average Amount Average
Assets (in $ millions) Yield % Liabilities (in $ millions) Cost %
Cash $ 950 0.0 Nonearning $ 4,080 0.0
Ratesensitive 11,590 7.0 Ratesensitive 18,850 5.0
Fixedrate 19,500 10.0 Fixedrate 10,900 6.5
Equity 1,790 N/A
Total $ 33,830 Total $ 33,830
As the assistant CFO of BM, you have been assigned to study the interestrate risk facing BM. Your first
step is to calculate BMs gap by using the data in the above schedule. Gap analysis gives a rough measure
of the banks overall interestrate risk. Next, you want to focus on ratesensitive assets and liabilities. Your
goal is to accurately predict the percentage change in the market value of BMs assets for a given change
in interest rates. You have already collected some data (Exhibit 62) on a representative portfolio of
3 bonds BM owns.
EXHIBIT 62
Characteristics of BMs representative bond portfolio
Payment Maturity Face
Bond Coupon rate % Frequency (Years) Yield % Value $
A 0.0 N/A 10 6.0 100
B 8.0 Annual 5 3.0 100
C 6.0 Semiannual 2 8.0 100
Required
2 a. Calculate BMs gap, and state the implications of such a gap.
2 b. Assuming a 1percentagepoint rise in rates, calculate the magnitude of the banks risk.
4 c. Determine the duration and price of Bond A and Bond C, respectively.
1 d. Bond B has a duration of 4.386 years and a price of $122.90. Calculate the duration of the portfolio.
2 e. Calculate the weighted average discount rate of the portfolio.
1 f. Indicate what the effect would be on this portfolio if all interest rates go up by 1%.
5 g. Based on your answers to parts (a) through (f), identify whether BM is exposed to the risk of an
increase or a decrease in interest rates. Altogether, BM has a $1 billion investment portfolio.
Historically, the return on this portfolio follows a normal distribution pattern, with an average daily
return of 0% and a standard deviation of 5.867%. Calculate the portfolios value at risk (VaR) at the
90%, 95%, and 99% levels and explain the meaning of these VaRs.
3 h. Explain how BM could use an interest rate swap and the Canadian Government Bond futures contracts
traded on the Montreal Exchange to hedge against the risk you identified in part (g).
END OF EXAMINATION
100
ADVANCED CORPORATE FINANCE [FN2]
EXAMINATION
FN2
Before starting to write the examination, make sure that it is complete and that there are no
printing defects. This examination consists of 7 pages and 21 pages of attachments. There are
6 questions for a total of 100 marks.
READ THE QUESTIONS CAREFULLY AND ANSWER WHAT IS ASKED.
To assist you in answering the examination questions, CGACanada includes the following glossary of terms.
Glossary of Assessment Terms
Adapted from David Palmer, Study Guide: Developing Effective Study Methods (Vancouver: CGACanada, 1996).
Copyright David Palmer.
Calculate Mathematically determine the
amount or number, showing
formulas used and steps taken. (Also
Compute).
Compare Examine qualities or characteristics
that resemble each other. Emphasize
similarities, although differences
may be mentioned.
Contrast Compare by observing differences.
Stress the dissimilarities of qualities
or characteristics. (Also Distinguish
between)
Criticize Express your own judgment
concerning the topic or viewpoint in
question. Discuss both pros and
cons.
Define Clearly state the meaning of the
word or term. Relate the meaning
specifically to the way it is used in
the subject area under discussion.
Perhaps also show how the item
defined differs from items in other
classes.
Describe Provide detail on the relevant
characteristics, qualities, or events.
Design Create an outcome (e.g., a plan or
program) that incorporates the
relevant issues and information.
Determine Calculate or formulate a response
that considers the relevant
qualitative and quantitative factors.
Diagram Give a drawing, chart, plan or
graphic answer. Usually you should
label a diagram. In some cases, add
a brief explanation or description.
(Also Draw)
Discuss This calls for the most complete and
detailed answer. Examine and
analyze carefully and present both
pros and cons. To discuss briefly
requires you to state in a few
sentences the critical factors.
Evaluate This requires making an informed
judgment. Your judgment must be
shown to be based on knowledge and
information about the subject. (Just
stating your own ideas is not
sufficient.) Cite authorities. Cite
advantages and limitations.
Explain In explanatory answers you must
clarify the cause(s), or reasons(s).
State the how and why of the
subject. Give reasons for differences
of opinions or of results. To explain
briefly requires you to state the
reasons simply, in a few words.
Identify Distinguish and specify the important
issues, factors, or items, usually based
on an evaluation or analysis of a
scenario.
Illustrate Make clear by giving an example,
e.g., a figure, diagram or concrete
example.
Interpret Translate, give examples of, solve, or
comment on a subject, usually
making a judgment on it.
Justify Prove or give reasons for decisions or
conclusions.
List Present an itemized series or
tabulation. Be concise. Point form is
often acceptable.
Outline This is an organized description. Give
a general overview, stating main and
supporting ideas. Use headings and
subheadings, usually in point form.
Omit minor details.
Prove Establish that something is true by
citing evidence or giving clear logical
reasons.
Recommend Propose an appropriate solution or
course of action based on an
evaluation or analysis of a scenario.
Relate Show how things are connected with
each other or how one causes another,
correlates with another, or is like
another.
Review Examine a subject critically,
analyzing and commenting on the
important statements to be made
about it.
State Clearly provide a position based on
an evaluation, e.g., Agree/Disagree,
Correct/Incorrect, Yes/No. (Also
Indicate)
Summarize Give the main points or facts in
condensed form, like the summary of
a chapter, omitting details and
illustrations.
Trace In narrative form, describe progress,
development, or historical events
from some point of origin.
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 1 of 21
Advanced Corporate Finance [FN2]
n
i) (1
FV
PV
+
=
Present value of a future value (FV)
amount
n = number of periods
i = rate per period
FV = PV(1+i)
n
Future value of a present value (PV)
amount
PV = PMT
1
1
(1+i)
n
i
(
(
(
(
(
Present value of an ordinary annuity
PMT = periodic payment
FV = PMT
1+i ( )
n
1
i
(
(
(
Future value of an ordinary annuity
PMT = periodic payment
r 1
C
C
r 1
CF
C PV
1
0
1
0
+
+ =
+
+ =
Present value of an asset discounted at
the lending and borrowing rate
C
0
= current cash flow
CF
1
= C
1
= cash flow expected next
period
r = market lending/borrowing rate
k 1
C
k 1
CF
PV
1 1
+
=
+
=
Present value of an asset discounted at
the cost of capital
k = cost of capital
0
1
0
1
C
k 1
C
C
k 1
CF
NPV
+
=
+
=
Net present value of a single future
cash flow
C
0
= cost of acquiring the asset
0
1
0
1
C
IRR 1
C
or C
IRR 1
CF
=
+
=
+
Internal rate of return for a current
cash outflow followed by a single cash
inflow
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 2 of 21
CCA
i
= C d (1 d/2)(1 d)
i2
CCA for year i
C = capital cost
d = capital cost allowance rate of the
class
i = year 2, 3, 4,
UCC
i
= C (1 d/2)(1 d)
i1
UCC at beginning of year i
PV =
CF
i
(1+ k)
i
+
S
n
(1+ k)
n
i=1
n
Present value of future incremental
cash flows without tax shield formula
method
CF
i
= expected cash flows at the end
of period i
k = discount rate
S
n
= salvage value at the end of n
periods
PV =
F
i
(1+ k)
i
i=1
n
+
S
n
(1+ k)
n
+ PVTS
Present value of future incremental
cash flows separating out the present
value of tax shields
F
i
= cash flow during period i,
excluding the tax shield
PVTS = present value of the tax shield
(
+
+
(
+
=
k 1
k 2
k) 2(d
T d C
PVTS
Present value of perpetual tax shields
(halfyear rule)
C = capital cost
d = capital cost allowance rate of the
class
T = tax rate
PVTSL
n
=
S
n
(1+ k)
n
(
(
d T
d + k
(
(
Present value of lost perpetual tax
shields with a continuing CCA pool
PVTSL
n
=
UCC
n
(1+ k)
n
(
(
d T
d + k
(
(
Present value of lost perpetual tax
shields when terminating the asset
class (excluding a recapture or
terminal loss)
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 3 of 21
(
(
(
+
+
(
+
+
+
+
+
=
=
k d
T d
k) (1
S
k 1
k 2
k) 2(d
T d C
k) (1
S
k) (1
F
PV
n
n
n
n
n
1 i
i
i
Present value of future incremental cash
flows using the tax shield formula
method with a continuing (open) CCA
pool
( )
(
(
+
+
(
(
(
+
+
(
+
+
+
+
+
=
=
n
n n
n
n
n
n
n
1 i
i
i
k) (1
T S UCC
k d
T d
k) (1
UCC
k 1
k 2
k) 2(d
T d C
k) (1
S
k) (1
F
PV
Present value of future incremental cash
flows using the tax shield formula
method when terminating the asset class
(closed pool)
0
n
n
n
n
n
1 i
i
i
C
k d
T d
k) (1
S
k 1
k 2
k) 2(d
T d C
k) (1
S
k) (1
F
NPV
(
(
+
+
(
+
+
+
+
+
=
=
Net present value with the present value
of tax shields for a continuing CCA pool
0
n
n n
n
n
n
1 i
n
n
i
i
C
k) (1
)T S (UCC
k d
T d
k) (1
UCC
k 1
k 2
k) 2(d
T d C
k) (1
S
k) (1
F
NPV
(
(
+
+
(
(
(
+
+
(
+
+
+
+
+
=
=
Net present value with the present value
of tax shields when terminating the asset
class (closed pool)
PI =
PV
C
0
=
NPV +C
0
C
0
Profitability index
ARR =
ACF
I
a
Average rate of return on book value
ACF = average annual incremental after
tax cash flows (net income) from
operations over the life of the project
I
a
= average book value of the investment
in the project
=
x all
P(x) x
Expected value (mean) of random
variable x
= =
= o
P(x) x ) E(x where ) E(x
P(x) ) (x
2
2 2 2 2
x all
2
Population variance of random variable x
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 4 of 21
( ) ( ) ( ) = o
x all y all
y x xy
y x, P y x
Population covariance of two random
variables x and y
y x
xy
xy
o o
o
=
Coefficient of correlation (population)
R =
R
1
+R
2
+... R
n
n
Mean of historical returns
( ) ( ) ( )
( ) =
+ +
= o
=
n
1 t
2
1
2
n
2
2
2
1 2
R
R R
n
1
n
R R
...
n
R R
n
R R
Variance of returns where each outcome
has an equal probability (population)
( ) ( ) ( )
( ) =
+ +
= o
=
n
1 t
2
1
2
n
2
2
2
1 2
R
R R
1  n
1
1  n
R R
...
1  n
R R
1  n
R R
Variance of returns where each outcome
has an equal probability (sample)
R
P
= w
1
R
1
+ w
2
R
2
+ ... + w
n
R
n
R
p
= w
i
R
i
i=1
n
Return of a portfolio based on the
weighted average of the asset returns
n = number of securities in the portfolio
w
i
= weight of return i, calculated as the
ratio of the amount invested in the
security i divided by the total investment
R
i
= return on security i
E R
P
( )= P
i
R
Pi
i =1
n
Expected return of a portfolio using
probabilities of states of the economy
i = 1, 2, , n
n = number of possible outcomes
P
i
= probability of outcome i
R
Pi
= portfolio return associated with
outcome i
( )  
2
n
1 i
P Pi i
2
p
R E R P = o
=
Variance of a portfolio (population)
E R
P
( )= w
i
E R
i
( )
i =1
n
Expected return on a portfolio using a
weighted average of expected returns
w
i
= weight of investment i in the
portfolio
n = number of investments in the portfolio
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 5 of 21
2
P
o = w
1
2
o
1
2
+ w
2
2
o
2
2
+ 2w
1
w
2
12
o
1
o
2
Variance of a twoasset portfolio
o
1
= standard deviation of investment 1
o
2
= standard deviation of investment 2
12
= correlation coefficient of
investments 1 and 2
o o
o
j i j i ij
n
1 j=
n
1 = i
2
P
w w
=
Variance of an nasset portfolio
ij
= correlation coefficient between
securities i and j
E(R
Pi
) = w
i
R
f
+ (1 w
i
)E(R
M
)
Expected return on a portfolio containing
a riskfree asset and the market portfolio
E(R
M
) = expected return on the market
portfolio
w
i
= portion invested in the riskfree asset
o
Pi
= (1 w
i
) o
M
Standard deviation of a portfolio
containing a riskfree asset and the market
portfolio
w
i
= portion invested in the riskfree asset
o
M
= standard deviation of the market
portfolio
E(R
Pi
) = R
f
+
o
o
Pi
M
[E(R
M
)
R
f
]
Capital market line
( )
2
M
M i iM
2
M
M i
i
R , R Cov
o
o o
=
o
= 
Beta of an asset
Cov(R
i
,R
M
) = covariance between return
on security i and market return R
M
R
i,t
= a
i
+ 
i
R
M,t
+ e
i,t
Total security return regression estimation
of beta
a
i
= constant term

i
= beta of security i
e
i,t
= error term
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 6 of 21
R
i,t
R
f,t
= a
i
+
i
(R
M,t
R
f,t
) + e
i,t
Security premium regression estimation of
beta (characteristic line)
R
i,t
R
f,t
= excess return over riskfree
rate (R
f
)
a
i
= constant term

i
= beta of security i
e
i,t
= error term
E(R
i
) = R
f
+ 
i
[E(R
M
) R
f
]
Capital asset pricing model
R
f
= riskfree rate
E(R
M
) = expected return on the market
portfolio

i
= beta of security i

p
= w
1

1
+ w
2

2
+ ... + w
n

n
Weighted average of a portfolio beta
w
i
= weight of security i in the portfolio

i
= beta of security i
i = 1, 2, 3, , n

L
= 
U
+ (1 T)(D/E)
U
Beta for a levered firm

U
= unlevered beta
T = tax rate
D = market value of debt
E = market value of equity
CV
i
=
o
i
E(R
i
)
Coefficient of variation
o
i
= standard deviation of project i values
E(R
i
) = expected return on project i
CV
i
=
o
i
E(NPV
i
)
Coefficient of variation for a capital
investment
o
i
= standard deviation of project i NPV
values
E(NPV
i
) = expected (mean) NPV of
project i
EAR =
amount of annual interest
outstanding balance
Effective annual rate/return for annual
interest payments
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 7 of 21
EAR= 1+
k
nom
m

\

.

m
1.0
Effective annual rate for interest payments
more frequent than an annual basis
k
nom
= nominal or stated rate
m = number of compounding periods per
year
EAR =
nom k
1.0 CB
Effective annual rate for a loan with a
compensating balance (annual interest
payments)
CB = compensating balance as a
percentage of the total loan amount
Face value =
funds needed
1.0CB
Face value needed to obtain the desired
funds for a loan
EAR =
m
1+
nom k
m
1.0 CB
(
(
(
(
1.0
Effective annual rate for a loan with a
compensating balance and interest
payments more frequent than an annual
basis
interest value face
interest
EAR
= or
k
0 . 1
k
EAR
nom
nom
=
Effective annual rate (nondiscounted
equivalent rate) for a discounted loan with
annual interest payments
EAR= 1+
k
nom
m
1.0
k
nom
m
(
(
(
(
m
1.0
Effective annual rate for a discounted loan
and interest payments more frequent than
an annual basis
Face value =
funds needed
1
k
nom
m
Face value needed to obtain the desired
funds for a discounted loan
EAR =
k
nom
1.0 k
nom
CB
Effective annual rate for loans with
compensating balances, terms of one or
more years, and annual interest payments
Face value =
funds needed
1.0 k
nom
CB
Face value needed to obtain the desired
funds for a discounted loan with a
compensating balance (annual interest
payments)
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 8 of 21
Call premium = C
y
N
r
/ N
Value of a call premium where the
premium declines in proportion to the
number of years remaining to maturity
C
y
= annual coupon
N
r
= number of years remaining to
maturity
N = number of years of original maturity
N =
d S
D + 1
(
(
+1
Number of shares required to elect a
desired number of directors
d = number of directors the minority
shareholders seek to elect
S = total number of shares outstanding
D = total number of directors to be elected
on R
=
on P
E
N +1
Theoretical value of a right during the
rightson period
P
on
= market price of the underlying share
during the rightson period
E = exercise price
N = number of rights required to purchase
one new share
ex R
=
ex P
E
N
Theoretical value of a right during the ex
rights period
P
ex
= market price of the underlying share
during the exrights period
Financial risk = o
L
o
U
Financial risk
o
L
= total risk to shareholders of the
levered firm as measured by the standard
deviation of returns (or profits)
o
U
= total risk to shareholders of the
unlevered firm as measured by the
standard deviation of returns (or profits)
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 9 of 21
V =
EBIT
L
k
=
EBIT
U
k
Value of a firm in the absence of
corporate taxes
V = V
L
= V
U
EBIT = perpetual earnings before
interest and taxes
k
L
= riskadjusted discount rate for the
levered firm
k
U
= riskadjusted discount rate for the
unlevered firm
k
L
= k
U
k
E
= k
U
+ k
U
k
B
( )
D
E

\

.

Cost of equity for a levered firm in the
absence of corporate taxes
k
U
= cost of equity of the unlevered firm
k
B
= beforetax cost of debt
D = market value of the firms debt
E = market value of the firms equity
V = D + E = D + E
L
Market value of the levered firm
k
L
= k
B
D
E + D
(
(
+ k
U
+ k
U
k
B
( )
D
E

\

.

(
(
E
E + D
(
(
Weighted average cost of capital for a
levered firm in the absence of corporate
taxes
PV (interest tax savings) = T
C
D Present value of interest tax savings for a
perpetual loan
T
C
= corporate tax rate
D = amount of debt
k
) T EBIT(1
= V
U
C
U
Value of an unlevered firm in the
presence of corporate taxes
D T +
V
= V
C U L
Value of a levered firm in the presence
of corporate taxes
V
U
= unlevered firms value
T
C
= corporate tax rate
D = amount of debt
k
E
= k
U
+ k
U
k
B
 
D
E
(
(
1 T
C
 
Cost of equity for a levered firm in the
presence of corporate taxes
k
U
= cost of equity to the unlevered firm
k
B
= beforetax cost of debt
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 10 of 21
WACC = k
L
=
D
V

\

.

k
B
1 T
C
( )
+
E
V

\

.

k
E
Weighted average cost of capital
V = value of the firm (debt + equity)
E
L
=
(EBIT I)(1 T
C
)
k
E
Estimated value of levered equity with
corporate taxes from cash earnings after
tax
E
L
= value of levered equity
I = total interest payment
k
E
= cost of levered equity
1 T
D
= (1 T
C
)(1 T
S
)
Tax parity between tax rate on interest
income, corporate tax rate, and personal
tax rate on income from shares
T
D
= tax rate on interest income
T
C
= corporate tax rate
T
S
= personal tax rate on income from
shares
V
U
=
EBIT(1 T
C
)(1 T
S
)
k
U
Value of an unlevered firm in the
presence of personal and corporate taxes
T
C
= corporate tax rate
T
S
= personal tax rate on income from
shares
k
U
= cost of equity of the unlevered firm
CF
L
= EBIT (1 T
C
)(1 T
S
) I (1 T
C
)(1 T
S
) + I (1 T
D
)
Cash flows from a levered firm
I = annual payments to debtholders
T
C
= corporate tax rate
T
S
= personal tax rate on income from
shares
T
D
= personal tax rate on income from
debt
V
L
= V
U
+ 1
1 T
C
( )
1 T
S
( )
1 T
D
( )
(
(
(
D
Value of a levered firm in the presence
of personal and corporate taxes
V
U
= value of the unlevered firm
D = market value of debt
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 11 of 21
V
L
= V
U
+ T
C
D PV(BC)
Value of a levered firm in the presence
of bankruptcy costs
V
U
= value of the unlevered firm
T
C
= corporate tax rate
D = market value of debt
PV(BC) = present value of the expected
bankruptcyrelated costs
DOL =
AEBIT
EBIT
ASales
Sales
Degree of operating leverage as a
function of sales level
A = change in the variable
DOL =
contribution margin
EBIT
=
(P V)Q
(P V)Q FC
Degree of operating leverage as a
function of a contribution margin
P = price per unit
V = variable cost per unit
Q = amount of sales in units
FC = fixed costs excluding financing
charges
FC costs variable sales
costs variable sales
FC VQ PQ
VQ PQ
DOL
=
=
Degree of operating leverage as a
function of variable costs
( )( )
S
PD T 1 I  EBIT
EPS
C
=
General formula for finding EPS from
EBIT
I = interest payments
T
C
= corporate tax rate
PD = preferred dividends
S = number of common shares
outstanding
EBIT
*
I
1

\

.

1 T
C
( )
PD
1
S
1
=
EBIT
*
I
2

\

.

1 T
C
( )
PD
2
S
2
Leverage indifference EBIT level
EBIT* = level of EBIT at which
earnings per share for each alternative is
equal
I = interest payments under each
alternative
T
C
= corporate tax rate
PD = preferred dividends under each
alternative
S = number of common shares
outstanding under each alternative
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 12 of 21
V
N
= V
C
+ T
C
D
N
Firm value after a new debt issue
V
C
= current (original) market value of
the firm
T
C
= corporate tax rate
D
N
= amount of required additional
(new) debt
APV = basecase NPV + PV of financing cash flows
= NPV
B
+ ITS FCNS + TSFC + ITCS IBC + OFRE
Adjusted present value
NPV
B
= basecase NPV
ITS = PV of interest tax shield
FCNS = PV of flotation costs of new
securities
TSFC = PV of tax shield on flotation
cost amortization
ITCS = PV of financingrelated
investment tax credits and subsidies
IBC = PV of incremental bankruptcy
costs
OFRE = PV of other financingrelated
effects
( ) ( )
( )
n
D
n
1 i
D
1 i
i
D
i
D
1
k 1
IP T
k 1
IP T
k 1
IP T
k 1
IP T
ITS
+
+ +
+
+
+
+ +
+
=
+
+
Present value of interest tax shields
IP
i
= interest payment in period i, where
i = 1, , n
T = corporate tax rate
k
D
= aftertax required rate of return on
the firms debt
n = number of interest payment periods
( ) ( ) ( )
n
D
n
1 i
D
1 i
i
D
i
D
1
k 1
FCA T
k 1
FCA T
k 1
FCA T
k 1
FCA T
TSFC
+
+ +
+
+
+
+ +
+
=
+
+
For equal period amortization of flotation costs at time zero,
n , (k VIFA P T(FC/n)
) k (1
T(FC/n)
TSFC
D
n
1 t
t
D
=
+
=
=
)
Present value of the tax shields on
flotation costs
FCA
i
= flotation cost amortization in
period i, where i = 1, , n
T = corporate tax rate
k
D
= aftertax required rate of return on
debt
n = number of amortization periods for
the flotation costs (lesser of 5 years or
the maturity of the securities)
FC = total flotation costs
PV(BC) = probability of financial distress (1 T) BC Present value of the aftertax bankruptcy
costs
BC = bankruptcy costs
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 13 of 21
IBC = PV(BC)
D
PV(BC)
E
Incremental present value of bankruptcy
costs
PV(BC)
D
= PV of bankruptcy costs
under debt financing
PV(BC)
E
= PV of bankruptcy costs
under equity financing
( )  
( )
costs flotation of PV
subsidies & credits tax investment of PV +
price salvage of PV +
D C
k 1
DP CCA T) 1 ( IP CCA RNV
NPV
0
n
1 i
i
E
i i i i i
ER
+
+
+
=
=
Net present value of a project (equity
residual method)
RNV
i
= revenues costs during period i
CCA
i
= capital cost allowance in period i
IP
i
= interest payment in period i
DP
i
= debt principal payments in period i
D = initial proceeds from the debt issue
C
0
= initial investment outlays
k
E
= cost of equity
n
n
1 i
1 i
i
r) (1
OC T) (1
r) (1
OC T) (1
r 1
OC T) (1
OC) PV(
+
A
+ +
+
A
+
+
A
= A
+
+
Present value of savings in operating
costs due to leasing
i = 1, , n
PV =
OCF
t
1+r ( )
t
t =1
n
+
1
1+r ( )
n
(
(
(
C
n
1+g ( )
r g
( )
(
(
(
=
OCF
t
1+WACC
( )
t
t =1
n
+
1
1+WACC
( )
n
(
(
(
OCF
n
1+g
( )
WACCg
( )
(
(
(
Firm valuation using operating cash
flows with WACC
OCF
t
= operating cash flow after tax,
including cash flow from (noncash)
depreciation for period t
r = discount rate
n = period of initial cash flow
forecasting
C
n
= OCF
n
= cash flow of the last
forecast period
g = perpetual growth rate after period n
NPV =
OCF
t
1+r ( )
t
t =1
n
+
1
1+r ( )
n
(
(
(
C
n
1+g ( )
r g
( )
(
(
(
C
0
NPV of acquisition using operating cash
flows (with WACC as the required
return)
C
0
= cost of the acquisition in terms of
new debt and share purchases
NPV = value to debtholders, preferred
shareholders, and common equity
shareholders
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 14 of 21
( ) ( )
( )
( )
0 0
n
n
n
1 t
t
t
equity
P B
g r
g 1 C
r 1
1
r 1
OCF
PV
(
+
(
(
+
+
+
=
=
Firm value to equity shareholders using
operating cash flows
B
0
= PV of debt
P
0
= PV of preferred shares
( ) ( )
( )
( )
( ) ( ) ( )
( )
( )
(
+
(
(
+
+
+
+
=
(
+
(
(
+
+
+
=
= =
=
g WACC
g 1 FCFF
WACC 1
1
WACC 1
NCI
WACC 1
OCF
g r
g 1 FCFF
r 1
1
r 1
FCFF
PV
n
n
n
1 t
t
t
n
1 t
t
t
n
n
n
1 t
t
t
Firm valuation using free cash flows to
the firm and WACC method
FCFF = free cash flow to the firm
NCI = net capital investments
g = perpetual growth rate of free cash
flow to the firm after period n
( ) ( ) ( )
( )
( )
( ) ( ) ( ) ( )
( )
( )
(
+
(
+
+
+
+
+
+
=
(
+
(
+
+
+
+
+
=
= = =
= =
g k
g 1 FCFF
k 1
1
k 1
T I
k 1
NCI
k 1
OCF
g r
g 1 FCFF
r 1
1
r 1
T I
r 1
FCFF
PV
U
n
n
U
n
1 t
t
D
C t
n
1 t
t
U
t
n
1 t
t
U
t
U
n
n
U
n
1 t
t
D
C t
n
1 t
t
U
t
Firm valuation using free cash flows to
the firm and APV method
I
t
T
C
= period income tax shield on
interest from longterm debt
r
U
= k
U
= unlevered cost of equity
r
D
= k
D
= aftertax cost of longterm debt
g = perpetual growth rate of free cash
flow to the firm after period n
(For perpetual funding with debt, the
debt tax shield could become a
perpetuity.)
( ) ( )
( )
( )
( ) ( ) ( ) ( )
( )
( )
( )
0 0
E
n
n
E
n
1 t
t
E
t t
n
1 t
t
E
t C t
n
1 t
t
E
t
n
1 t
t
E
t
E
n
n
E
n
1 t
t
E
t
P B
g k
g 1 FCFE
k 1
1
k 1
P B
k 1
PDiv ) T 1 ( I
k 1
NCI
k 1
OCF
g k
g 1 FCFE
k 1
1
k 1
FCFE
PV
+ +
(
+
(
(
+
+
+
+
+
+
+
+
=
(
+
(
(
+
+
+
=
= = = =
=
Firm valuation using free cash flows to
equity and ERM method
FCFE = free cash flow to equity
k
E
= return to levered equity
OCF
t
= operating cash flow for period t
NCI
t
= net capital investment for period t
I
t
= interest payment on debt for period t
T
C
= effective corporate tax rate
PDiv
t
= preferred share dividend for
period t
B
t
= bond repayment for period t
P
t
= preferred share repayment for period
t
B
0
= initial bond amount
P
0
= initial preferred share amount
g = perpetual growth rate of free cash
flow to equity after period n
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 15 of 21
( )
( )
( ) g r
g 1 D
g r
D
PV
0 1
0
+
=
=
Valuation using dividend cash flows and
ERM method
PV
0
= present value at the current time
(end of period 0)
D
1
= cash dividend payment at the end
of period 1
D
0
= cash dividend payment at the end
of period 0
r = discount rate = k
E
g = perpetual growth rate in dividends
( ) ( )
( )
(
(
(
+
+
+
=
+
= g r
D
r 1
1
r 1
D
PV
1 n
n
n
1 t
t
t
0
or
( ) ( )
( )
( )
(
+
(
(
+
+
+
=
= g r
g 1 D
r 1
1
r 1
D
PV
n
n
n
1 t
t
t
0
Valuation using dividend cash flows and
ERM method with initial period of
specific dividend amounts
n = number of periods of specific
dividend amounts
( )
( )
( ) ( )
( )
(
(
(
+
+
(
(
+
+
=
+
2
1 n
n n
n
1
1
1
0
g r
D
r 1
1
r 1
g 1
1
g r
D
PV
or
( )
( )
( ) ( )
( )
( )
(
(
+
(
(
+
+
(
(
+
+
=
2
n
1 1
n n
n
1
1
1
0
g r
g 1 D
r 1
1
r 1
g 1
1
g r
D
PV
Valuation using dividend cash flows and
ERM method with initial period of high
dividend growth
g
1
= initial high growth rate
g
2
= perpetual growth at the market rate
=
=
(
(
+
(
(
+
=
n
1 t
t
t
n
1 t
t
t
) i 1 (
CF
t
) i 1 (
CF
D
Duration of a security
CF
t
= cash flow expected at time t
t = number of periods until cash flow
payment
i = yield to maturity
n = number of anticipated cash flows
m
i
1
D
r
V
V
+
~
A

.

\
 A
Volatility (percentage change) of a
securitys value from changes in the
required yield (stated per year)
D = duration measured in years
V = market value of the security
AV = change in market value of the
security
Ar = change in interest rates
i = yield to maturity
m = number of compounding periods per
year
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 16 of 21
r
m
i
1
V D
V A
+
= A or
m
i
1
r V D
+
A
Change in market (dollar) value of a
security for a given change in interest
rate (stated per year)
ANII = Ar gap Change in net interest income due to gap
Ar = expected change in interest rates
n i 1
n n i i 1
P
V V V
V D V D V D
D
+ + +
+ + +
=
1
Duration of a portfolio
D
i
= durations of i securities
(i = 1, , n)
V
i
= market values of i securities
(i = 1, , n)
r
d 1
V D
V
W
P P
P
A
+
= A or
W
P P
d 1
r V D
+
A
Change in a portfolios value as a
function of a weighted average expected
change in individual yields
D
p
= portfolios duration
Ar = change in interest rates
d
W
= weighted average discount rate,
where the component rate for an asset is
the yield to maturity per compounding
period
n
V ... V V
n
V
n
m
n
i
... V
m
i
V
m
i
w
d
2 1
2
2
2
1
1
1
+ + +
+ + +
=
Weighted average interest rate for a
portfolio
i = quoted interest rate for a bond
m = number of compounding periods per
year for the bond
V = market value of the bond
Price index = 100 i
d
Price index
i
d
= annual discount rate in percent
F
0,T
= S
0
(1 + Rf
0,T
Rh
0,T
) Futures price for financial futures
F
0,T
= futures price at time 0 for delivery
at time T
S
0
= spot price at time 0
Rf
0,T
= rate at time 0 on the riskfree
asset maturing at time T
Rh
0,T
= rate of cash payments expected
to be paid by the underlying asset
between time 0 and time T
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 17 of 21
F
0,T
= S
0
(1 + Rf
0,T
Rh
0,T
) + H
0,T
Futures price for nonfinancial or general
assets
H
0,T
= holding costs from time 0 to time
T
F
0,T
= S
0
[1 + Rf
0,T
E(D
0,T
)]
General pricing formula for index
futures prices
E(D
0,T
) = opportunity loss for the
contract holder from the loss of
dividends during the contract period
F
0,T
=
0 S
1 +
R
D
N
D
(
(
MN
D
1 +
R
F
N
F
(
(
MN
F
Forward exchange rate using the interest
rate parity relationship
F
0,T
= forward rate at time 0 quoted in
domestic currency at which the foreign
currency can be purchased for delivery
at time T
S
0
= spot rate at time 0 quoted in
domestic currency at which the foreign
currency can be purchased for immediate
delivery
R
D
= annual interest rate on the domestic
currency
R
F
= annual interest rate on the foreign
currency
N
D
= number of compounding periods
per year for the domestic interest rate
N
F
= number of compounding periods
per year for the foreign interest rate
M = number of years until the forward
contract matures
F
C
F
M
M
F
V
HR =
Hedge ratio
V = market value of assets/liabilities to
be hedged
F
F
= face value of the security
underlying the futures contract
M
C
= maturity of the assets/liabilities to
be hedged
M
F
= maturity of the security underlying
the futures contract
= correlation of the change in volatility
of the rate to be hedged in relation to the
change in volatility of the rate on the
security underlying the futures contract
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 18 of 21
ATB = ABA
Change in value of Tbill rates as a
function of the bankers acceptance
futures rates
Price =
$100
1+ yield
days to maturity
365

\

.

Price of a shortterm, pure discount
security
C = SN(d
1
) EN(d
2
) e
rT
2
T
T
rT
E
S
ln
d
1
o
+
o
+ 
.

\

=
d
2
= d
1
oT
BlackScholes optionpricing model for
a call
S = share price
E = exercise price
r = continuously compounded riskfree
rate
T = time to expiration measured in years
o = standard deviation of the shares
continuously compounded rate of return
N(d) = probability that a standardized,
normally distributed, random variable
will be less than or equal to d
( ) ( ) ( ) ( )  
(
+ =
L U
L U
L
L
d N d N
d d
d * d
d N * d N
Interpolation formula to determine N(d
1
)
or N(d
2
)
N(d*) = probability that an outcome will
be less than or equal to d*
d
L
= value of d in the normal curve table
that is smaller than and nearest to d*
d
U
= value of d in the normal curve table
that is greater than and nearest to d*
Present value = Ee
rT
Present value of the exercise price at the
expiry date
C + Ee
rT
= S + P Putcall parity relationship
P = put premium
C = call premium
S = share price
E = cash exercise price on option
expiration
r = riskfree rate
T = time to expiration of the options
P = C + Ee
rT
S Value of a put option in terms of the put
call parity relationship
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 19 of 21
P = [1 N(d
2
)] Ee
rT
S[1 N(d
1
)] Value of a put option using the Black
Scholes formula
Security value = value of straight security + option value
Value of a security with builtin options
AR
X
= R
FX X
R
FL X
Change in degree of risk from borrowing
in fixedrate market compared with the
floatingrate market
R
FX X
= risk to lenders from lending to X
in the fixedrate market
R
FL X
= risk to lenders from lending to X
in the floatingrate market
AR
Y
= R
FL Y
R
FX Y
Change in degree of risk from borrowing
in the floatingrate market compared
with the fixedrate market
R
FL Y
= risk to lenders from lending to Y
in the floatingrate market
R
FX Y
= risk to lenders from lending to Y
in the fixedrate market
r
eff, ann
= e
r
cnt,ann
1
r
cnt,ann
= ln 1+r
eff,ann
( )
Conversion of annual continuously
compounded rate to annual effective rate
and vice versa
r
eff,ann
= effective annual return
r
cnt,ann
= continuously compounded
annual return
IC = average inventory / (COGS/365)
RC = average accounts receivable / (CS/365)
PD = (average accounts payable + average accruals) / (COGS/365)
Cash conversion period = IC + RC PD
NWC = (IC PD)
COGS
365
(
(
+ RC
CS
365

\

.

+ AC ANP CPLD
Cash conversion cycle and net working
capital
IC = inventory conversion period
RC = receivables conversion period
PD = payables deferral period
COGS = cost of goods sold
CS = annual credit sales
NWC = net working capital
AC = average cash level
ANP = average notes payable
CPLD = current portion of longterm
debt
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 20 of 21
EFN2J11 [FN2.1011] CGACanada, 2011 Attachment 21 of 21
SFN2J11 CGACanada, 2011 Page 1 of 9
CGACANADA
ADVANCED CORPORATE FINANCE [FN2] EXAMINATION
June 2011
SUGGESTED SOLUTIONS
Marks Time: 4 Hours
12 Question 1
Note:
2 marks each
Sources:
a. 3) Topic 1.4 (Level 2)
b. 4) Topic 1.8 (Level 1)
c. 1) Topic 2.2 (Level 1)
d. 4) Topic 5.4 (Level 1)
e. 3) Topic 5.5 (Level 1)
f. 2) Topic 9.4 (Level 1)
18 Question 2
Note:
3 marks each
Sources:
a. 1) Topic 4.3 (Level 1)
Sales / Sales = (EBIT / EBIT) / DOL = 10% / 1.5 = 6.67%
Sales = (1 + 6.67%) $500,000 = $533,333
b. 3) Topic 3.1 (Level 1)
Effective annual rate = % 80 . 14 1
% 9 1
2
% 13
1
2
=




.

\

+
c. 2) Topic 8.2 (Level 1)
F
0,T
=
F
D
N M
F
F
N M
D
D
0
N
R
+ 1
N
R
+ 1
S
= 1.5183
( )
( )
4971 . 1
% 93 . 2 1
% 49 . 1 1
1 1
1 1
=
+
+
Continued
SFN2J11 CGACanada, 2011 Page 2 of 9
d. 3) Topic 5.6 (Level 1)
Aftertax cost of debt = 10% (1 30%) = 7%
Present value of the CCA tax shield for the machine:
495 , 21 $
) 07 . 0 1 ( ) 07 . 0 2 . 0 ( 2
) 07 . 0 2 ( 3 . 0 2 . 0 000 , 100
=
+ +
+
Present value of aftertax operating costs = $5,000 (1 30%) PVIFA (7%, 5) = $14,351
Present value of lease payments (annuity due):
$25,000 PVIFA (7%, 5) (1 + 7%) = $109,680
Present value of tax shield on lease payments:
$25,000 30% PVIFA (7%, 5) = $30,751
Equivalent loan = $109,680 + $21,495 $14,351 $30,751 = $86,073
e. 3) Topic 2.4 (Level 1)
ARR = ACF / I
a
= 
.

\
 +

.

\
 +
2
0 000 , 250
5
3 000 , 30 2 000 , 50
= 30.40%
f. 3) Topic 3.10 (Level 1)
The exrights date is Tuesday, June 21, 2011, 2 business days before the record date, Thursday,
June 23, 2011. June 22, 2011 is one day after the exrights date. The exrights share price can be
calculated as follows:
00 . 1 $
1 1
00 . 10 $ 00 . 12 $
1 N
E P
R
on
on
=
+
=
+
=
00 . 1 $
1
00 . 10 $ ) 00 . 1 $ 00 . 12 ($
N
E P
R
ex
ex
=
=
=
P
ex
= P
on
R
ex
= $12.00 $1.00 = $11.00
Alternatively,
P
ex
= P
on
R
on
= $12.00 $1.00 = $11.00
SFN2J11 CGACanada, 2011 Page 3 of 9
15 Question 3
Source: Topics 7.1, 8.4, 10.4, and 10.5 (Level 1)
2 a. The firms sales peak during the months of October, November, and December. Net working capital
doubles during this period. Given that the balance sheet is as of November 30, the current working
capital includes the seasonal portion. Therefore, the seasonal portion of net working capital can be
estimated as:
($2,200,000 $450,000 $100,000) / 2 = $825,000
1 b. The firm has $2,200,000 in current assets and $720,000 in current liabilities, excluding the current
portion of longterm debt. Therefore, $1,480,000 of its current assets is financed with longterm debt
or with shareholders equity.
The seasonal portion of net working capital is much higher than the amount of shortterm borrowing.
Therefore, the firm seems to be following a conservative strategy in which part of the seasonal
working capital needs are financed with longterm debt or equity.
Continued...
SFN2J11 CGACanada, 2011 Page 4 of 9
8 c. Cash conversion period
= Inventory conversion period + Receivables conversion period Payables deferral period.
(1) Inventory conversion period:
=

.

\

365
sold goods of cost
inventory average
=

.

\

365
75 . 0 000 , 000 , 10 $
000 , 200 , 1 $
= 58.4 days
(1) Receivables conversion period:
=

.

\

365
sales credit annual
receivable accounts
=

.

\

365
75 . 0 000 , 000 , 10 $
000 , 850 $
= 41.4 days
(1) Payables deferral period:
=

.

\

+
365
sold goods of cost
deferrals other payable accounts
=

.

\

+
365
75 . 0 000 , 000 , 10 $
000 , 100 $ 000 , 450 $
= 26.8 days
(1) The operating cycle:
= 58.4 + 41.4 = 99.8 or 100 days
(1) The cash conversion period:
= 99.8 26.8
= 73 days
(3) The cash conversion period represents the average period of time elapsing between the payment of a
supplier and the time that payment from sales is received. It shows how long the firm has to wait to
receive cash from sales after paying the obligations that produced these sales. It also indicates whether
the firm is a user or supplier of trade credit. The positive cash conversion period means that GRU has
to wait approximately 73 days for cash coming from sales after paying the obligations. GRU is
therefore a supplier of trade credit.
Continued...
SFN2J11 CGACanada, 2011 Page 5 of 9
4 d. The term structure of interest rates suggests that the market expects rates to go down (downward
sloping yield curve). This is according to the pure expectations model of term structure.
GRU is following a conservative policy and has its interest rates locked in for a longer term. It will not
benefit from the declining interest rates. In addition, it also faces the risk of having to invest excess
cash on hand at decreasing rates.
One possible alternative for GRU to avoid this disadvantage is to engage in an interest rate swap. It
should try to find a party (with the help of an investment banker) who wants to lock in interest rates.
In a possible interest rate swap, GRU will pay a floating rate to receive the fixed rate. Combined with
its existing position paying a fixed rate GRU will pay a floating rate in the end.
15 Question 4
Source: Topics 1.7, 2.7, and 4.3 (Level 1)
5 a. The current cost of equity: k
E
= 5% + 1.8 (11% 5%) = 15.8%
Current value of equity: M 924 . 113 $
% 8 . 15
%) 40 1 ( %) 10 M 400 $ M 70 ($
E
L
=
=
Current price per share = $113.924M / 8M shares = $14.24
Total value of BCT: V
L
= E
L
+ D = $113.924M + $400M = $513.924M
Current debttoasset ratio = $400M / $513.924M = 77.83%
10 b. i) To calculate the total value of equity that BCT should issue to reduce the debttoasset ratio
to 40%:
Currently, V
L
= $513.924M = V
U
+ T
c
D = V
U
+ 40% ($400M)
V
U
= $513.924M 40% $400M = $353.924M
After the restructuring, D
NEW
= 40% V
L, NEW
V
L,
NEW
= V
U
+ T
c
D
NEW
= $353.924M + 40% 40% V
L,
NEW
= $353.924M + 0.16 V
L,
NEW
V
L,
NEW
= $353.924M/0.84 = $421.3381M
D
NEW
= 40% V
L,
NEW
= 40% $421.3381M = $168.5352M
The total value of equity to be issued = the change in debt = $400M $168.5352M
= $231.4648M
ii) The value of equity after the restructuring:
E
L
= $421.3381M $168.5352M = $252.8029M
The cost of equity = % 8 . 15 % 61 . 12
M 8029 . 252 $
%) 40 1 ( %) 10 M 5352 . 168 $ M 70 ($
< =
The new cost of equity is decreased to 12.61% from the previous 15.8%.
SFN2J11 CGACanada, 2011 Page 6 of 9
20 Question 5
Source: Topics 5.4, 6.3, 6.5, 6.7, and 6.8 (Level 1)
3 a. This is an example of a horizontal merger and acquisition. Following are reasons why ABL might
want to acquire AIM:
1. To achieve operating economies of scale and/or scope to lower operating costs
2. To diversify operations to a larger geographical area
3. To strategically eliminate a competitor
4. To gain market power and control over pricing policies
5. To achieve faster growth and be a dominant player in the industry
Note:
Only 2 reasons required
3 b. You will need the unlevered cost of equity (capital) for operating cash flows and the aftertax cost of
debt for side effects to apply the APV method to free cash flows to the firm.
The levered beta is 1.5, the longterm debttoequity ratio is 40%, and the income tax rate 40%. The
riskfree rate is 6% and the expected market return is 12%.
The unlevered beta is 2097 . 1
%) 40 1 ( 4 . 0 1
5 . 1
U
=
+
= 
Unlevered cost of equity for operating cash flows = k
U
= 0.06 + 1.2097 (0.12 0.06) = 13.26%
Aftertax cost of debt for side effects to the APV method = 0.08 (1 0.4) = 4.8%
5 c. The value may be calculated as follows:
Year
1 2 3 4 5
Free cash flows to the firm $ 6,500 $ 6,950 $ 7,650 $ 8,050 $ 9,000
Tax shield on interest payments 1,680 1,600 1,520 1,440 1,360
(Previous year principal Interest rate Tax rate)
PV of FCFF (including residual):
PV =
$6,500
(1+0.1326)
1
+
$6,950
(1+0.1326)
2
+
$7,650
(1+0.1326)
3
+
$8,050
(1+0.1326)
4
+
$9,000
(1+0.1326)
S
+
$9,000 (1+0.03)
(1+0.1326)
S
(0.1326 0.03)
= $74,626
PV of interest tax shield:
PV =
$1,680
(1+0.048)
1
+
$1,600
(1+0.048)
2
+
$1,520
(1+0.048)
3
+
$1,440
(1+0.048)
4
+
$1,360
(1+0.048)
S
= $6,652
The total value of the firm including longterm debt is $74,626 + $6,652 = $81,278.
The value of the common shares, assuming the original debt is repaid, is $81,278 $52,500
= $28,778.
Continued...
SFN2J11 CGACanada, 2011 Page 7 of 9
1 d. The appropriate discount rate for the FCFE method is the levered cost of equity.
The riskfree rate is 6%, and the expected market return is 12%. The levered beta is 1.5.
Thus, k
E
= 0.06 + 1.5 (0.12 0.06) = 0.15 = 15%
3 e. The FCFE method starts with the FCFF and adjusts for financing costs. The FCFF is reduced by the
amount of debt repayments and the aftertax cost of debt. Thus, the year 1 numbers are calculated as
follows:
FCFF $ 6,500
Aftertax interest (lagged principal) 52,500 0.08 (1 0.4) (2,520)
Longterm debt repayment 50,000 52,500 (2,500)
FCFE $ 1,480
Note:
The net working capital change and the annual amortization do not enter this calculation.
5 f. PV of FCFE for the common shares (including residual):
PV =
$1,480
(1+0.15)
1
+
$2,050
(1+0.15)
2
+
$2,870
(1+0.15)
3
+
$3,390
(1+0.15)
4
+
$4,460
(1+0.15)
S
+
($4,460) (1+0.03)
(1+0.15)
S
(0.15 0.03)
= $27,909
Since ABL wants to retain the longterm debt, it will not need to pay more. The total value of the
assets (common shares + LTD) is $27,909 + $52,500 = $80,409.
LAB has offered $100,000 for the assets (including LTD) of AIM. The equivalent value for AIM is
$81,278 according to the FCFF method and $80,409 according to the FCFE method. These valuations
are close, so if the assumptions are correct, ABL should not bid for AIM. LAB seems to be bidding
too much for AIM.
SFN2J11 CGACanada, 2011 Page 8 of 9
20 Question 6
Source: Topics 3.3, 7.1, 7.4, 7.5, 7.6, 7.9, 8.3, 8.4, and 9.4 (Level 1)
2 a. BMs gap = ratesensitive assets ratesensitive liabilities
= $11,590 million $18,850 million
= $7,260 million
The gap is negative, which means that if rates drop, the bank is positioned to benefit. In this case, the
interest costs on financing will decrease more than the decrease in the interest income; thus, net
income will increase. On the other hand, if rates rise, the bank will experience a decrease in realized
net income.
2 b. The magnitude of the banks risk can be measured using the formula:
ANII = Ar gap = (+1%) ($7,260 million) = $72.60 million
Assuming a 1percentagepoint rise in rates, NII will drop by $72.6 million.
4 c. The duration of Bond A is equal to its maturity, that is, 10 years because it is a zerocoupon bond.
Its price = $100 PVIF (6%, 10 years) = $55.84
The duration of Bond C can be calculated as follows:
Time Cash flow Discount rate PVIF PV (CF) t PV (CF)
1 3 0.04 0.9615 2.8845 2.8845
2 3 0.04 0.9246 2.7738 5.5476
3 3 0.04 0.8890 2.6670 8.0010
4 103 0.04 0.8548 88.0444 352.1776
Price = 96.3697 368.6107
Duration = 368.6107 / 96.3697 = 3.825 / 2 = 1.9125 years
Its price is $96.37.
1 d. The duration of the portfolio =
years
V V V
V D V D V D
D
n i i
n n i i i i
P
659 . 4
37 . 96 90 . 122 84 . 55
9125 . 1 37 . 96 386 . 4 9 . 122 10 84 . 55
1
1 1
=
+ +
+ +
=
+ + +
+ + +
=
+
+ +
2 e. The weighted average discount rate of the portfolio:
% 96 . 3
37 . 96 90 . 122 84 . 55
% 4 37 . 96 % 3 9 . 122 % 6 84 . 55
d
w
=
+ +
+ +
=
1 f. If all interest rates go up by 1%, this portfolio will decrease by
33 . 12 $ ) 01 . 0 (
% 96 . 3 1
) 37 . 96 90 . 122 84 . 55 ( 659 . 4
r
d 1
V D
V
W
P P
P
= +
+
+ +
= A
+
= A
Continued...
SFN2J11 CGACanada, 2011 Page 9 of 9
5 g. BM is at risk of a higher interest rate. If interest rates increase, the value of BMs portfolio will
decrease.
At a 90% confidence level for a onetailed test, z = 1.28.
90% VaR = $1 billion 0.05867 1.28 = $75.0976 million
At a 95% confidence level for a onetailed test, z = 1.645.
95% VaR = 1 billion 0.05867 1.645 = $96.5122 million
At a 99% confidence level for a onetailed test, z = 2.33.
99% VaR = $1 billion 0.05867 2.33 = $136.7011 million
The VaRs are calculated for a distribution (normal) around the current value, which is generally
assumed to be the distribution mean. Thus, the 90% VaR of $75.0976 million is the dollar loss that
may occur in one day in the portfolio with a 90% probability. There is only a 10% chance that the loss
will exceed $75.0976 million on any day, based on the assumptions, and a 90% chance that any loss
will be less than or equal to $75.0976 million. The other VaRs can be interpreted similarly.
3 h. BM is exposed to the risk of increasing interest rates, which is likely to happen when the Canadian
economy recovers from a recession. If BM uses an interest rate swap to lock in at the current relatively
low rates, it will pay the fixed rate to receive the floating rate. Combined with its existing position
paying a floating rate BM will pay a fixed rate in the end.
BM can sell Canadian Government Bond futures contracts traded on the Montreal Exchange in such a
way that any decrease in the value of the bond portfolio resulting from a higher interest rate is offset
by a profit on its futures position (sell high to buy low). BM may also buy put options on these same
futures contracts. With options, BM will get protection from the downside risk and at the same time
retain the upside profitable potential.
END OF SOLUTIONS
100
FN2J11 CGACanada, 2011
CGACANADA
ADVANCED CORPORATE FINANCE [FN2] EXAMINATION
June 2011
EXAMINERS COMMENTS
General Comments
Though improving significantly from the March 2011 session, the overall performance on this
examination was still unsatisfactory.
Compared with many previous examinations, the questions on this examination were relatively
straightforward and simple. Candidates provided satisfactory answers to Question 2. The performance on
the remaining questions was unsatisfactory.
The results were consistent with the previous examinations and revealed the same strengths and
weaknesses of average candidates. Candidates were good at applying formulas to calculate the quantitative
answers in Question 2. However, candidates lacked a solid understanding of some basic concepts and of
overall financial decisionmaking processes, which contributed to their unsatisfactory performance on the
remaining questions.
For example, in Question 3, although the topic (working capital management) covered by this question
was tested in a similar way in past examinations, the performance on this question was the poorest of the
entire examination. Part (a) required candidates to calculate the estimated seasonal portion of net working
capital, which could be easily calculated first by subtracting accounts payable and accrued expenses from
current assets and then by dividing the difference by 2. However instead, many candidates applied the
complicated formula used to forecast future net working capital (the last formula in the formula sheet) to
calculate the required number. The poor performance on this basic accounting and financial management
concept demonstrated that while some candidates are able to apply formulas to calculate numbers, they do
not fully understand why the numbers are calculated or how to explain the numbers. Candidates also had
difficulty with the remaining parts of this question. A number of candidates were unable to explain cash
conversion period in part (c). Many candidates thought that the cash conversion period was the same as
accounts receivable.
In brief, candidates are strongly encouraged to spend time reading the course materials and understanding
the basic concepts. Before attempting past examinations, they must understand and be able to finish the
assignment questions without any help from their peers or instructors. While working on the assignment
questions, candidates must make sure they are able to calculate all the numbers on their calculators even
though an Excel spreadsheet is used to do all the calculations.
Specific Comments
Question 1 Multiple choice (Level 1)
This question included six qualitative multiplechoice items. The overall performance was almost
satisfactory. The best performance was on parts (e) (lease financing) and (f) (currency risk hedging
alternatives). The performance on part (b) (ethical behaviour) was also satisfactory. Candidates had
difficulty with parts (a) (market efficiency), (c) (relevant cash flows to a capital budgeting decision), and
(d) (weighted average cost of capital).
Continued...
FN2J11 CGACanada, 2011
Question 2 Multiple choice (Level 1)
The overall performance on this question was satisfactory and the best of the entire examination,
indicating that candidates were strong in solving relatively simple quantitative questions. This question
consisted of six quantitative multiplechoice items. The poorest performance was on part (e) (average rate
of return). The best performance was on parts (a) (operating leverage), (b) (a term loan with a
compensating balance), and (c) (forward exchange rate). The performance on parts (d) (equivalent loan)
and (f) (rights offering) was also satisfactory.
Question 3 Working capital management (Level 1)
Performance on this question was unsatisfactory and the poorest in the entire examination. Parts (a) and (c)
were mostly quantitative and parts (b) and (d) qualitative. Similar questions were on past examinations,
but the results demonstrated that candidates did not quite understand the basic concepts in this topic.
In addition to the issues and problems discussed in the general comment section, candidates had difficulty
with the cash conversion period and alternative financing policies regarding net working capital needs.
While twothirds of candidates were able to calculate the operating cycle and cash conversion period in
part (c), fewer candidates correctly explained the significance of the cash conversion period. Many
candidates simply put the process of calculating this number into words. Quite a few candidates
misinterpreted the negative cash conversion period as an indication that the firm was in serious financial
trouble.
In addition to the misinterpretation, a few candidates even made up an incorrect cash conversion formula
modeled after formulas for inventory conversion periods and receivables conversion periods and then
provided incorrect explanations for them. In answering part (b), candidates also made up various incorrect
answers.
In answering part (d), while most candidates were able to correctly identify that future interest rates were
expected to decrease, only a handful of candidates provided the correct answer (using an interest rate swap
or BA futures).
Question 4 Capital structure (Level 1)
Performance on this question was also unsatisfactory, although this question was simpler than the
questions covering the same topic on past examinations.
The performance on part (a) was better than that on part (b). The majority of candidates were able to
correctly calculate the value of the firm and the share price/equity value in part (a) before recapitalization,
demonstrating their solid understanding of value (a fundamental concept in finance) and their competence
in calculating the value of a firm and the share price. Yet quite a number of candidates incorrectly
calculated the per share value of a firm (debt plus equity) as the share price. A few candidates made up
their own formula for calculating the cost of equity as EBIT divided by the value of the firm.
The same problems with this question remained: (1) a number of candidates did not quite understand the
MM proposition with tax scenario they did not see that several things would change at the same time in
part (b), where the firm issued new equity capital to substitute debt, including the total value of the firm,
the value of equity, and the risk measured by a lower cost of equity. They incorrectly calculated the
amount of debt after the recapitalization by multiplying the change in debt ratio (from 78% to 40%) by the
value of the firm from part (a) (before the recapitalization). While they did not apply the correct formula
(VL = VU + T D) in part (b) to calculate the value of the firm after the equity issue, this formula was
used incorrectly in part (a) by many candidates to find the value of equity. (2) Some candidates appear to
have been influenced by past examinations: they calculated the number of new shares to issue and the new
share price after recapitalization, which were not required in this examination. As well, another formula
the leverageindifference EBIT level was incorrectly used by some candidates to calculate the number
of shares outstanding after the restructuring in part (b). Candidates need to improve their understanding of
when to use each formula appropriately.
Continued...
FN2J11 CGACanada, 2011
Question 5 Valuation and mergers and acquisitions (Level 1)
Performance on this question was unsatisfactory. This is a straightforward question that is both qualitative
and quantitative. This question was designed to test candidates understanding of a realworld common
practice after a financial crisis (mergers and acquisitions) and their ability to apply the project valuation
methods to analyze an acquisition case.
The major difficulty with this question was that candidates were unable to apply two different project
valuation methods (APV(FCFF) in part (c) and FCFE in parts (e) and (f)) to calculate the value of a firm.
Many candidates seemed to be unfamiliar with different types of cash flows (FCFF and FCFE) and some
of them forgot the time value of money: they simply added together the cash flows over the severalyear
period without properly discounting them to arrive at the value of the firm or the equity.
The unsatisfactory performance on this question should remind candidates of the importance of
understanding basic finance concepts. Finance is not only about numbers and about calculations. Without
a good understanding of the basic concepts, it is not possible to correctly calculate even simple numbers.
Question 6 Treasury risk management (Level 1)
Performance on this question was unsatisfactory but the second best of the entire examination.
The major difficulty with this question was part (g). Though candidates should have some experience with
VaR from their course work, quite a few of them were unable to calculate VaRs at different confidence
levels and many candidates were unable to explain the meaning of VaR. Many of them simply stated that
VaR was the amount at risk or the amount that affects the portfolio, which does not explain it. Others used
words such as vary, fluctuate, and change in explaining VaR, essentially misinterpreting the onetail
statistics as the twotail statistics.
Other issues with this question were: (1) In part (e), many candidates were unable to explain how to use an
interest rate swap and government bond futures to hedge against interest rate risk; (2) In part (a), a few
candidates incorrectly calculated the gap either by subtracting liabilities from assets or by subtracting the
average financing cost from the yield on assets and incorrectly interpreting the gap; and (3) In parts (c)
through (e), many candidates confused the bond yield with the coupon rate (a few candidates even stated
that the zerocoupon bond has a zero yield). Though the duration and price of Bond B were given in the
examination, a number of candidates spent time calculating them. Some candidates also calculated the
duration of the zerocoupon bond, which actually was its maturity.
Once again, the unsatisfactory performance on this question should remind candidates to spend sufficient
time and effort to learn financial concepts and terms, which are the foundation of this course. Simply
memorizing answers to questions on past examinations will not result in good marks on the next
examination, nor will it improve candidates realworld problemsolving skills.
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