AMERICAN UNIVERSITY IN BULGARIABUS 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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Part A: Multiple choice questions (2.5 points each, 15 points in total):1. Which of the following statements is CORRECT?

a. Corporations generally are subject to fewer regulations and more favorable tax treatment than sole proprietorships and partnerships. This is why corporations do most of the business in the United States.

b. 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.

c. 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.

d. Because of their simplified organization, it is easier for sole proprietorships and partnerships to raise large amounts of outside capital than it is for corporations.

e. Bond covenants are an effective way to resolve conflicts between shareholders and managers.

Answer: C

2. Which of the following statements is CORRECT?a. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of

the periods.b. If a series of unequal cash flows occurs at regular intervals, such as once a year,

then the series is by definition an annuity.c. The cash flows for an annuity due must all occur at the ends of the periods.d. The cash flows for an annuity must all be equal, and they must occur at regular

intervals, such as once a year or once a month.e. If some cash flows occur at the beginning of the periods while others occur at the

ends, then we have what the textbook defines as a variable annuity.Answer: D

3. Which of the following statements is CORRECT?a. The statement of cash flows reflects cash flows from operations, but it does not

reflect the effects of buying or selling fixed assets.b. The statement of cash flows shows where the firm’s cash is located; indeed, it

provides a listing of all banks and brokerage houses where cash is on deposit.c. The statement of cash flows reflects cash flows from continuing operations, but it

does not reflect the effects of changes in working capital. d. The statement of cash flows reflects cash flows from operations and from

borrowings, but it does not reflect cash obtained by selling new common stock.e. The statement of cash flows shows how much the firm’s cash - the total of

currency, bank deposits, and short-term liquid securities (or cash equivalents) - increased or decreased during a given year.

Answer: E

4. Jefferson City Computers has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)?

a. A sharp increase in its forecasted sales and a corresponding increase in its total assets.

b. A switch to a just-in-time inventory system and outsourcing production.c. The company reduces its dividend payout ratio.d. The company switches its materials purchases to a supplier that sells on terms of

1/5, net 90, from a supplier whose terms are 3/15, net 35.e. The company discovers that it has excess capacity in its fixed assets.

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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. The company’s bonds are downgraded.b. Market interest rates rise sharply.c. Market interest rates decline sharply.d. The company's financial situation deteriorates significantly.e. Inflation fluctuates significantly.

Answer: C

6. Which of the following statements is CORRECT, assuming stocks are in equilibrium?a. The dividend yield on a constant growth stock must equal its expected total return

minus its expected capital gains yield.b. Assume that the required return on a given stock is 13%. If the stock’s dividend is

growing at a constant rate of 5%, its expected dividend yield is 5% as well.c. A stock’s dividend yield can never exceed its expected growth rate.d. 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.e. Other things held constant, the higher a company’s beta coefficient, the lower its

required rate of returnAnswer: A

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Part B: Simple problems (8 points each, 32 in total)7. (8 points) The Talley Corporation expects to have sales of $12 million. Costs other than

depreciation are expected to be 75% of sales, and depreciation is expected to be $1.5 million. All sales revenues will be collected in cash, and costs other than depreciation must be paid for during the year. Talley’s federal-plus-state tax rate is 40%. Berndt has no debt.

a. Set up an income statement. What is Talley’s expected net cash flow?b. Suppose Congress changed the tax laws so that Talley’s depreciation expenses

doubled. No changes in operations occurred. What would happen to reported profit and to net cash flow?

Solution:a. Income Statement

Sales revenues $12,000,000Costs except depreciation 9,000,000Depreciation 1,500,000EBT $ 1,500,000Taxes (40%) 600,000Net income $ 900,000Add back depreciation 1,500,000 Net cash flow $ 2,400,000

b. If depreciation doubled, taxable income would fall to zero and taxes would be zero. Thus, net income would decrease to zero, but net cash flow would rise to $3,000,000. Talley would save $600,000 in taxes, thus increasing its cash flow:

∆CF = T(∆Depreciation) = 0.4($1,500,000) = $600,000.

8. (8 points) Tandem Video Product’s sales are expected to increase by 20% from $5 million in 2010 to $6 million in 2011. Its assets totaled $3 million at the end of 2010. Tandem Video is already at full capacity, so its assets must grow at the same rate as projected sales. At the end of 2010, current liabilities were $1 million, consisting of $250,000 of accounts payable, $500,000 of notes payable, and $250,000 of accruals. The after tax profit margin is forecasted to be 5%, and the forecasted payout ratio is 70%.Use the EFN equation to forecast Tandem 's additional funds needed for the coming year.

Solution:EFN = (A0*/S0)∆S – (L0*/S0)∆S – (PM)(S1)(1 – payout rate)

= $1,000,000 – $1,000,000 – 0.05($6,000,000)(1 – 0.7)

= (0.6)($1,000,000) – (0.1)($1,000,000) – ($300,000)(0.3)

= $600,000 – $100,000 – $90,000

= $410,000.

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9. (8 points) Suppose Wilsen Product Manufacturing sold an issue of bonds with a 10-year maturity, a $1000 par value, a 10% coupon rate, and semi annual interest payments.

a. Two years after the bonds were issued, the going rate of interest on bonds such as these fell to 6%. At what price would the bond sell? (Note: two years have already passed)

b. Suppose that, 2 years after the bonds were issued, the going interest rate had risen to 12%. At what price would the bond sell? (Note: two years have already passed)

c. Suppose, 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). What would happen to the price of the bond over time?

Solution:a. The bonds now have an 8-year, or a 16-semiannual period, maturity, and their

value is calculated as follows:

Calculator solution: Input N = 16, I/YR = 3, PMT = 50, FV = 1000, PV = ? PV = $1,251.22.

b. Calculator solution: Change inputs from Part (a) to I/YR = 6, PV = ? PV = $898.94.

c. The price of the bond will decline toward $1,000, hitting $1,000 (plus accrued interest) at the maturity date 8 years (16 six-month periods) hence.

10. (8 points) You buy a share of MIT Corporation stock for $21.40, which pays a dividend of $1.050/share. You expect it to pay dividends of $1.1070, $1.1449, and 1.2250 in Year 1, 2 and 3 respectively, and you expect to sell it at a price of $26.22 at the end of the year 3.

a. Calculate the growth rate in dividends for the first year.b. Calculate the expected dividend yield for the same year.c. Assuming that the calculated growth rate is expected to continue, what is this

stock’s expected total rate of return?

Solution:a. g = $1.1070/1.050 – 1 = 5.43%.

Calculator solution: Input N = 1, PV = -1.050, PMT = 0, FV = 1.1070, I/YR = ? I = 5.43%.

b. Dividend Yield = D1/P0 = $1.107/$21.40 = 5.17%.

c. s= D1/P0 + g = 5.17% + 5.43% = 10.6%.

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C. Problem solving (13 points each, 39 in total)11. (13 points) The most recent financial statements for Maritin, Inc. are shown below:

Income Statement Balance sheetSales $19,200 Assets $93,000 Debt $20,400Cost $15,550 Equity $72,600Taxable income $3,650 Total $93,000 Total $93,000Taxes (34%) $1,241Net income $2,409

Assets and costs are changing proportionally to sales. Debt and common equity do not change. A dividend of $963.60 was paid and Maritin wishes to maintain a constant dividend payout ratio of 0.40. Next year’s sales are projected to be $23,040. What external financing is needed? (Note: Note: construct the pro-forma balance sheet to find EFN).

Solution:An increase of sales to $23,040 is an increase of:Sales increase = ($23,040 – 19,200) / $19,200Sales increase = .20 or 20%

Assuming costs and assets increase proportionally, the pro forma financial statements will look like this:

Income Statement Balance sheetSales $23,040.0

0Asset

s$111,60

0Debt $20,400.0

0Cost $18,660.0

0Equit

y$72,600.0

0Taxable income $4,380.00 Additions to RE 1,734.48Taxes (34%) $1,489.20Net income $2,890.80 Total $111,60

0Total $94,734.4

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The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or:

Dividends = 0.40($2,890.80)Dividends = $1,156.32

Addition to retained earnings = $2,890.80 – 1,156.32Addition to retained earnings = $1,734.48

And the new equity balance is:Equity = $72,600 + 1,734.48 = $74,334.48

So the EFN is:EFN = Total assets – Total liabilities and equityEFN = $111,600 – 94,734.48 = $16,865.52

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12. (13 points) A company currently pays a dividend of $2 per share, that is, D0 = $2. It is estimated that the company’s dividend will grow at a rate of 20% per year for the next 2 years, then at a constant rate of 7% thereafter. The company’s stock has a beta of 1.2, the risk-free rate is 7.5%, and the market return is 11.5%. 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) = 7.5% + (11.5% – 7.5%)1.2 = 12.3%.

Step 2: Calculate the expected dividends: D0 = $2.00D1 = $2.00(1.20) = $2.4D2 = $2.00(1.20)2 = $2.88D3 = $2.88(1.07) = $3.0816

Step 3: Calculate the PV of the expected dividends: PVDiv = $2.40/(1.123) + $2.88/(1.123)2 = $2.14 + $2.28 = $4.42.

Step 4: Calculate P2 : = D3/(Rs – g) = $3.0816/(0.123 – 0.07) = $58.143.

Step 5: Calculate the PV of :PV = $58.14/(1.123)2 = $46.10.

Step 6: Sum the PVs to obtain the stock’s price:= $4.42 + $46.08 = $50.50.

Alternatively, using a financial calculator, input the following:CF0 = 0, CF1 = 2.40, and CF2 = 60.99 (2.88 + 58.14), I/YR = 12.3 and solve for NPV = $50.52.

P1 = P0(1 + g) = $50.52(1 + 0.20) = $60.624

13. (13 points) Suppose you have invested only in two stocks, A and B. You expect that returns on the following three states of the economy, which are equally likely to happen, to be as follows:

State of the economy Return on stock A (%) Return on stock B (%)Bear 6.3% -3.7%Normal 10.5 6.4Bull 15.6 25.3

a. Calculate the expected return of each stock using equal probabilities of occurrence. b. Calculate the standard deviation of returns of each stock using equal probabilities

of occurrence.c. Calculate the coefficient of variation for each stock. Which stock is riskier?

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Solution:

a. Expected return A = (6.3% + 10.5% + 15.6%)/3 = 10.8%Expected return B = (-3.7% + 6.4% + 25.3%)/3 = 9.3%

b. Variance A2 = [(0.063 – 0.108)^2 + (0.105 – 0.108)^2 + (0.156 – 0.108)^2]/3 =

0.0014459Standard deviation A = 0.038026, or 3.8026%Variance B

2 = [(-0.037 – 0.093)^2 + (0.064 – 0.093)^2 + (0.253 – 0.093)^2]/3 = 0.014447Standard deviation B = 0.120196, or 12.0196%

c. Coefficient of variation (A) = 0.038026/0.1080 = 0.352Coefficient of variation (B) = 0.120196/0.0.093 = 1.292

Stock B is riskier as it has higher standard deviation and coefficient of variation.

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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:

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Part D: Bonus questions (2 points each, 4 in total)1. Which of the following classes use case-based learning approach?

a. Corporate finance 1 and 2b. Political Anthropologyc. Introduction to Musicd. Beginning Drawing

Answer A.

2. Who is the current chair of the Business Department?a. Lucia Mireeb. Donald Bradyc. Steve Sullivand. Cy Reed

Answer B.

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