Lahore School of Economics: Final Semester Exam May 2021

LAHORE SCHOOL OF ECONOMICS
FINAL SEMESTER EXAM MAY 2021

SUBJECT:FINANCIAL MANAGEMENT 1
COURSE:BSC E 2ND YEAR DOUBLE MAJORS IN
ACCOUNTING AND FINANCE
SEMESTER:SPRING SEMESTER 2021
EXAM DURATION:2.5 HOURS(30 mins for uploading)
EXAM MARKS:100 Marks
COURSE INSTRUCTOR:Sana kamal
DATE:20thMay 2021
Note:All questions are mandatory.
Q1)a) Kaufman Enterprises has bonds outstandingwith a $1,000 face value
and 10 years left until maturity. They have an 11% annual couponpayment,
and their current price is $1,175. The bonds may be called in 5 years at 109%
offace value (Call price=$1,090).
a. What is the yield to maturity?
b. What is the yield to call if they are called in 5 years?
c. Which yield might investors expect to earn on these bonds? Why?
d. The bond’s indenture indicates that the call provision gives the firm the
right to callthe bonds at the end of each year beginning in Year 5. In Year 5,
the bonds may becalled at 109% of face value; but in each of the next 4
years, the call percentage will decline by 1%. Thus, in Year 6, they may be
called at 108% of face value; in Year 7, theymay be called at 107% of face
value; and so forth. If the yield curve is horizontal and interest rates remain
at their current level, when is the latest that investors might expect the firm
to call the bonds?
(15 marks)
Q2) A bond’s expected return is sometimes estimated by its YTM and
sometimes by its YTC.Under what conditions would the YTM provide a better
estimate, and when would the YTCbe better?
(5 marks)
Q3) Suppose you won the lottery and had two options: (1) receiving
$0.5million or (2) taking a gamble in which at the flip of a coin you receive
$1 million if a headcomes up but receive zero if a tail comes up.
a. What is the expected value of the gamble?
b. Would you take the sure $0.5 million or the gamble?
c. If you chose the sure $0.5 million, would that indicate that you are a risk
averter or arisk seeker?d. Suppose the payoff was actually $0.5 million—that
was the only choice. You now facethe choice of investing it in a U.S. Treasury
bond that will return $537,500 at the end ofa year or a common stock that
has a 50-50 chance of being worthless or worth$1,150,000 at the end of the
year.
(1) The expected profit on the T-bond investment is $37,500. What is the
expected dollar profit on the stock investment?
(2) The expected rate of return on the T-bond investment is 7.5%. What is
the expected rate of return on the stock investment?
(3) Would you invest in the bond or the stock? Why?
(4) Exactly how large would the expected profit (or the expected rate of
return) have to be onthe stock investment to make you invest in the stock,
given the 7.5% return on the bond?
(5) How might your decision be affected if, rather than buying one stock for
$0.5 million,you could construct a portfolio consisting of 100 stocks with
$5,000 invested in each?Each of these stocks has the same return
characteristics as the one stock—that is, a50-50 chance of being worth zero
or $11,500 at year-end. Would the correlationbetween returns on these
stocks matter? Explain
(20 Marks)
Q4) If investors’aversion to risk increased, would the risk premium on a high-

beta stock increase by more or less than that on a low-beta stock? Explain.
(5 marks)
Q5) Your broker offers to sell you some shares of Johnson & Co. common
stock that paid a dividend of $2.00yesterday.Johnson’s dividend is expected
to grow at 5% per year for the next 3 years. If you buy the stock, you plan to
hold it for 3 years andthen sell it. The appropriate discount rate is 12%.
a. Find the expected dividend for each of the next 3 years; that is, calculate
D1,D2, and D3.Note that D0=$2.00.
b. Given that the first dividend payment will occur 1 year from now, find the
presentvalue of the dividend stream; that is, calculate the PVs of D1,D2, and
D3and then sumthese PVs.
c. You expect the price of the stock 3 years from now to be $34.73; that is,
you expect P^3toequal $34.73. Discounted at a 12% rate, what is the present
value of this expected futurestock price? In other words, calculate the PV of
$34.73.
d. If you plan to buy the stock, hold it for 3 years, and then sell it for $34.73,
what is themost you should pay for it today?
e. calculate the present value of this stock. Assume that g=5% andthat it is
constant.f. Is the value of this stock dependent upon how long you plan to
hold it? In other words,if your planned holding period was 2 years or 5 years
rather than 3 years, would this affect the value of the stock today, P^0?
Explain.
(15 Marks)
Q6) The following table gives Foust Company’s earnings per share for the
last 10 years.The common stock, 7.8 million shares outstanding, is now
(1/1/09) selling for $65.00 pershare. The expected dividend at the end of the
current year (12/31/09) is 55% of the 2008EPS. Because investors expect
past trends to continue, g may be based on the historicalearnings growth
rate. (Note that 9 years of growth are reflected in the 10 years of data.
The current interest rate on new debt is 9%; Foust’s marginal tax rate is 40%;
and its capital structure, considered to be optimal, is as follows:
(12 marks)
Q7) Klose Outfitters Inc. believes that its optimal capital structure consists of
60%common equity and 40% debt, and its tax rate is 40%. Klose must raise
additional capital tofund its upcoming expansion. The firm will have $2 million
of new retained earnings with a cost of rs=12%. New common stock in an
amount up to $6 million would have a cost of re=15%. Furthermore, Klose
can raise up to $3 million of debt at an interest rate of rd=10%and an
additional $4 million of debt at rd=12%. The CFO estimates that a
proposedexpansion would require an investment of $5.9 million. What is the
WACC for the last dollar raised to complete the expansion?
(8 Marks)
Q8a) An electric utility is consid-ering a new power plant in northern Arizona.
Power from the plant would be sold in thePhoenix area, where it is badly
needed. Because the firm has received a permit, the plant would be legal;
but it would cause some air pollution. The company could spend anadditional
$40 million at Year 0 to mitigate the environmental problem, but it would
notbe required to do so. The plant without mitigation would cost $240 million,
and theexpected net cash inflows would be $80 million per year for 5 years.
If the firm does investin mitigation, the annual inflows would be $84 million.
Unemployment in the area wherethe plant would be built is high, and the
plant would provide about 350 good jobs. Therisk-adjusted WACC is 17%.
1). Calculate the NPV and IRR with and without mitigation.
2). How should the environmental effects be dealt with when evaluating this
project?
3). Should this project be undertaken? If so, should the firm do the
mitigation?
(8 marks)
b) An oil drilling company must choose betweentwo mutually exclusive
extraction projects, and each costs $12 million. Under Plan A, all the oil
would be extracted in 1 year, producing a cash flow at t=1 of $14.4 million.
Under PlanB, cash flows would be $2.1 million per year for 20 years. The
firm’s WACC is 12%.
1. Construct NPV profiles for Plans A and B, identify each project’s IRR, and
show theapproximate crossover rate.
2). Is it logical to assume that the firm would take on all available
independent,average-risk projects with returns greater than 12%? If all
available projects withreturns greater than 12% have been undertaken, does
this mean that cash flows frompast investments have an opportunity cost of
only 12% because all the company can dowith these cash flows is to replace
money that has a cost of 12%? Does this imply thatthe WACC is the correct
reinvestment rate assumption for a project’s cash flows?
(12 Marks)

Lahore School of Economics: Final Semester Exam May 2021

Uploaded by

Copyright:

Available Formats

Lahore School of Economics: Final Semester Exam May 2021

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lahore School of Economics: Final Semester Exam May 2021

Uploaded by

Copyright:

Available Formats

LAHORE SCHOOL OF ECONOMICS

FINAL SEMESTER EXAM MAY 2021

Q4) If investors’aversion to risk increased, would the risk premium on a high-

You might also like