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SESSION 1 FORMAL EXAMINATIONS JUNE 2015

EXAMINATION DETAILS:
Unit Code:

AFIN253

Unit Name:

Financial Management

Duration of exam:

2 hours + 10 minutes Reading Time

Total no. of questions:

25 Multiple Choice/True False Questions (50 marks) & 5 Full Response

Questions (50 marks).

Total no. of pages:

18

INSTRUCTIONS:
1. There are a total of 100 marks available. Marks for each question, or part of a question, are given in
parentheses.
2. Record your answers to the multiple choice questions on the General Purpose Answer Sheet using
a blue/black pen or 2B pencil.
3. All Questions must be answered.
4. Write your answers in the spaces provided.
5. Illegible handwriting risks loss of marks.
MATERIALS PERMITTED / NOT PERMITTED:
No dictionaries are permitted.
A non-programmable calculator (no text retrieval capacity) is permitted.
Financial calculators may be used.
One double-sided A4 hand-written sheet may be used. Students are required to hand in all their
notes with their exam paper.
Mobile telephones must be turned off and left at the front of the room.

Question

Part A

Total

Out of

50

10

10

10

10

10

100

Mark

Candidates are required to obey all instructions provided by the Final Examination Supervisor and must refrain from communicating in any way
with another student once they have entered the final examination venue.
Candidates may not write or mark the exam materials in any way during reading time.
Candidates may only access authorised materials during this examination. A list of authorised material is available on this cover sheet. If it is
alleged you have breached these rules at any time during the examination, the matter may be reported to the University Discipline Committee
for determination.

Rough Working Paper

Part A
Section A
The following 10 questions are worth 2 marks each.
1. The systematic risk (beta) of a portfolio is ________ by holding more risk free securities.
A)
B)
C)
D)

Decreased
Increased
Unchanged
Cannot say for sure

2. The ________ rate is a price for a currency denominated in another currency.

A)
B)
C)
D)

Foreign exchange
Reversion
Marginal
Interest

3. Repurchases and special dividends are useful for making ________ and ________
distributions to shareholders.
A)
B)
C)
D)

Large, frequent
Large, infrequent
Small, frequent
Small, infrequent

4. When corporate tax rates decline, the net cost of debt financing
A)
B)
C)
D)

Is unchanged
Decreases.
Increases
None of the above

5. Which of the following statements is FALSE?

A) A security's beta is the expected percentage change in the return of the security for a 1%
change in the return of the market portfolio.
B) Securities whose returns tend to move one for one with the market on average have a beta
of zero.
C) Securities that move less than the market have lower betas.
D) Beta represents the amount by which risks that affect the overall market are amplified or
dampened in a given share or investment.
6. Because investors can eliminate unsystematic risk 'for free' by diversifying their portfolios,
they________ a risk premium for bearing it.
A)
B)
C)
D)

Are indifferent about

Require
Do not require
None of the above

7. Which of the following is NOT a way that a firm can increase its dividend per share?
A)
B)
C)
D)

By decreasing its shares outstanding

By increasing its dividend payout rate
By increasing its retention rate
By increasing its earnings (net income)

8. A corner store grocer is contemplating putting a large neon sign over his store. It would cost
$50,000, but is expected to bring an additional $24,000 of profit to the store every year for five
years. Would this project be worthwhile if evaluated using a discounted payback period of two years
or less and if the cost of capital is 10%?
A) Yes, since the cash flows after two years are greater than the initial investment.
B) Yes, since it will pay back its initial investment in two years.
C) No, since the value of the cash flows over the first two years is less than the initial
investment.
D) Yes, since the value of the cash flows into the store, in present dollars, is greater than the
initial investment.
9. An investment will pay $205,000 at the end of next year for an investment of $183,000 at the
start of the year. If the market interest rate is 8% over the same period, should this
investment be made?
A) No, because the investment will yield $6240 less than putting the money in a bank.
B) Yes, because the investment will yield $2360 more than putting the money in a bank.
C) Yes, because the investment will yield $7360 more than putting the money in a bank.
D) Yes, because the investment will yield $4280 more than putting the money in a bank.
10. Which of the following statements is FALSE?
A) Bonds typically make two types of payments to their holders.
B) By convention the coupon rate is expressed as an effective annual rate.
C) Bonds are securities sold by governments and corporations to raise money from investors
today in exchange for promised future payments.
D) The time remaining until the repayment date is known as the term of the bond.

Section B
The following 5 questions are worth 3 marks each.
11. Michael Morgan has been doing a lot of research about options on the internet as well as
from reputable textbooks. He has discovered the following five facts and wishes to know
which ones are correct.
i)
ii)
iii)
iv)
v)

European Options provide more flexibility than American Options.

American Options are usually able to be bought at a cheaper price than European
options all things being equal.
The value of an Option is the sum of its intrinsic value and time value
The time value of an option may have little effect on the value of an option in certain
circumstances.
American options can only be exercised on their maturity date

Which statements above are correct?

a)
b)
c)
d)

ii, iii, iv & v

i, iii, & iv
iii & iv
iii & v

12. Mary Zeffer has a keen interest in the factors that impact on the value of an option. A friend
of hers, Gerry Song, has provided her with the following information:
i)
ii)
iii)
iv)
v)

an increase in the volatility of the underlying asset will increase the value of an option
A decrease in the value of the underlying asset will decrease the value of an option
An increase in the spot (market) price of an underlying asset will increase the value of a
put option and decrease the value of a call option
An increase in the spot(market) price of an underlying asset will increase the value of a
call option and decrease the value of a put option
Time value is not relevant to option pricing

Which statements above are correct?

a)
b)
c)
d)

i, iii, v
i, iv, v
ii, iv,
i, iv

13. Michael Smith has recently purchased an American call option on BHP. At the time of the
purchase the spot price of BHP shares was $55, the exercise price was $53 and the option
premium he paid was $2.50. The current price of BHP shares is $56. Which of the following
statements is incorrect.
a)
b)
c)
d)

The breakeven price for Michael Smith is $55.50

The time value of the option is currently 50 cents
The intrinsic value of the option is currently $3
The intrinsic value of an option can never be negative

14. Malcolm Noad is interested in the use of a Put to manage the risk in his share portfolio. He
has been told a number of things and is really not sure what is true. Which of the following
statements in relation to puts is true.
a)
b)
c)
d)

A put will be impacted by the time to maturity the same way a call is
A long put option is exactly the same as a short call option.
A put option is suitable only for investors in the Asia-Pacific region.
A put gives you an obligation to sell the underlying asset.

15. Which of the following statements regarding options is correct?

a)
b)
c)
d)

American options may only be traded on the New York Stock Exchange
Bermudan options are only available to residents of Bermuda
The Black-Scholes-Merton Model of option pricing is named after British singer Cilla Black
Options may be bought on both recognized exchanges and OTC.

Section C
True/False Questions
The following questions are worth 1.5 marks each. In answering these questions you should
choose A for True and B for False on the multiple choice answer sheet provided.
16. Capital Markets theory recommends that a company capital structure is best to be made up
of 100% debt
17. An American put option will, all things being equal, have a value less than or equal to a
European put option.
18. If financial markets expected interest rates to increase by .25% and they increased by .5%
the strength of the Australian dollar should increase
19. If you were quoted a rate of 0.9000 USD / AUD and 1.2 NZD / AUD then the exchange rate
for USD / NZD would be 1.333.
20. The CAPM is one of a number of methods available to calculate the cost of equity for an
organization.
21. The cost of funding a project should be included in a capital budgeting analysis where the
interest is repaid within the term of the project duration.
22. The dividend discount model used in share valuation assumes that all dividends are
constant over time.
23. The intrinsic value of a call option can be defined as Max(spot exercise, 0).
24. If a company issued a special class as equity whereby dividends were treated as an interest
expense by the tax office and thereby attracted a tax deduction, it would be necessary to
multiply the return by (1-tax rate) when including it in any after tax weighted average cost of
capital calculation.
25. If you were told by your best friend that sunk costs and opportunity costs were the same
thing you would think your friend was incorrect.

Part B
Short Answer Questions (50 Marks)
Question 1 (10 Marks)
Semilon Ltd is a company funded by a mixture of debt, equity and preference capital. The
marginal tax rate of Semilon is 30%.
The company expects to pay a dividend of $2 next year and achieve a growth rate of 3%. The
current market price of the share is $12 and the Beta of the stock is .7. There are currently 1
million shares on issue.
The company also has debt with a maturity of 5 years that pays annual coupons. The
coupon rate is 6% and the bond was issued with a face value of $1000 and is currently priced
at $1000. There are presently 6000 bonds on issue.
Preference shares have a face value of $100 and pay an annual dividend of 8%. The current
market price of the preference share is $80. When the share was issued at face value the
value of the stock issued was $2m.
(a) Calculate the weights of the ordinary shares, bonds and preference shares that would
be used in a WACC calculation for Semilon Ltd.
(2 Marks)
Market value of ordinary shares: 1m*$12=$12m
Market value of debt: $1000*6000=$6m
Market value of preference shares: $2m/$100*$80=$1.6m
Total value of company: $12m+$6m+$1.6m=$19.6m (1 mark)
Weight of ordinary shares: $12m/$19.6m=61.22%
Weight of debt: $6m/$19.6m=30.61%
Weight of preference shares: $1.6m/$19.6m=8.16% (1 mark)

(b) Calculate the cost of equity of the ordinary shares.

Cost of equity=D1/P0+g=$2/$12+3%= 19.67%

(2 Marks)

(c) Calculate the cost of debt on an after tax basis.

(2 Marks)

After-tax of debt=Before-tax of debt*(1-tax rate)=6%*(1-0.3)=4.2%

(2 marks for correct after-tax cost, and 1 mark for pre-tax cost only)

(d) Calculate the cost of equity of the preference shares.

(2 Marks)

Dividend=$100*0.08=$8
Cost of preference shares=$8/$80=10%

(e) Calculate the WACC on an after tax basis.

WACC=61.22%*19.67%+30.61%*4.2%+8.16%*10%=14.14%

(2 Marks)

Question 2 (10 Marks)

Toblerone Ltd is a leading manufacturer of Swiss Clocks but is looking to expand into the
production of watches. A business opportunity has presented itself and has the following
cash flows.
Period 0
Period 1-3
Periods 4 6
Periods 7-9
Period 10

-$5m USD
0
$1m USD per year
$2m USD per year
$4m USD.

The discount rate used by the company is 8% per annum.

a) Calculate the payback period. If the company accepts all projects with a payback less
than 8 years should the project be accepted?
(2 Marks)
Use the following table to assist in calculating your answer (Show all working)
Year

Cash flows

Cumulative cash flows

-5m

-5m

-5m

-5m

-5m

1m

-4m

1m

-3m

1m

-2m

2m

2m

2m

2m

4m

10

4m

8m

Payback period=7 years

7 years<8 years, accept the project.
(1 mark for correct payback period, 1 mark for accept/reject based on earlier answer.)

10

b) I) Calculate the discounted payback period. If the company accepts all projects with a
discounted payback less than 8 years should the project be accepted?
(2 Marks)
II) Calculate the cash flow required in year 10 for the project to have a zero NPV
(2 Marks)

Use the following table to assist in calculating your answer (Show all working)
Year

Present values of cash flows

Cumulative cash flows

-5m

-5m

-5m

-5m

-5m

1m/1.08^4=0.735m

-5m+0.735m=-4.265m

1m/1.08^5=0.6806m

-4.265m+0.6806m=-3.5844m

1m/1.08^6=0.6302m

-3.5844m+0.6302m=-2.9542m

2m/1.08^7=1.167m

-2.9542m+1.167m=-1.7872m

2m/1.08^8=1.0805m

-1.7872m+1.0805m=-0.7067m

2m/1.08^9=1.0005m

-0.7067m+1.0005m=0.2938.m

10

4m/1.08^10=3.7003m

1.0516m+3.7003m=4.7519m

(i) Discounted payback period=8+0.7067/1.0005=8.706 years

8.706>8, reject the project
(1 mark for correct payback period, 1 mark for accept/reject based on earlier answer.)

(ii) 0=0.2938m+CF(10)/1.08^10, CF(10)= - 0.634m

11

c) The head of finance has informed you that any project with a payback of less than 8
years is guaranteed to generate shareholder wealth.
Is she correct?
(1 Mark)
Why or Why not?
(1 Mark)
How would you respond to such a statement?
(2 Marks)
Solution:

She is incorrect. (1 mark)

The project may have large negative cash flows in the later years, which will harm
shareholders interests because the NPV of the project can still be negative. (1
marks)
In addition to payback period, we should consider other capital budgeting methods to
evaluate a potential project, such as NPV and IRR. Payback periods gives us some
useful information, but since it ignores the cash flows after the payback time, we
should never make a decision based solely on that. (2 marks)

12

Question 3 (10 Marks)

a) Assume the market can have five possible states: very good, good, neutral, bad and
very bad. The probabilities for each of the states are given in the table below, and so
are the returns of two assets, Asset 1 and Asset 2 for each of these states:

(i)

State

Probability

Asset 1 returns

Asset 2 returns

Very good

0.1

14%

8%

Good

0.2

8%

5%

Neutral

0.4

2%

2%

Bad
Very bad

0.2
0.1

-4%
-10%

-4%
-8%

Calculate the expected return of Asset 1 and Asset 2. Using the two assets,
how could you construct a portfolio with expected return of 1.7%?
(2 Marks)

Expected return of asset 1=0.1*14%+0.2*8%+0.4*2%+0.2*(-4%)+0.1*(-10%)=2% (0.5 mark)

Expected return of asset 2=0.1*8%+0.2*5%+0.4*2%+0.2*(-4%)+0.1*(-8%)=1% (0.5 mark)
W=weight of asset 1
W*2%+(1-w)*1%=1.7% (0.5 mark)
Weight of asset 1=70%
Weight of asset 2=30% (0.5 mark)

(ii)

Calculate the standard deviation of returns for Asset 1.

(2 Marks)

Variance of asset 1
=0.1*(14%-2%)^2+0.2*(8%-2%)^2+0.4*(2%-2%)^2+0.2*(-4%-2%)^2+0.1*(-10%-2%)^2
=0.00432 (1 mark)
SD1=0.06573 (1 mark)

(iii)

Assuming that the standard deviation of Asset 2 is 1% and the correlation

between returns from Asset 1 and Asset 2 is =0.94, what is the standard
deviation of a portfolio with equal weights w1= w2=0.5?
(4 Marks)

Variance of portfolio= 0.5^2*0.01^2+0.5^2*0.00432+2*0.94*0.5^2*0.01*0.06573=0.001434

SD of portfolio = 0.03786
(No deduction of mark for carried-on errors)

13

b) The CAPM describes the relationship between risk and expected return of a particular
asset. Explain why we choose to use beta instead of standard deviation to measure
risk in the model.
(2 Marks)

Standard deviation measures the assets total risk while beta measures its systematic risk.
(1 mark)
In the CAPM model, idiosyncratic risk is irrelevant because it can be diversified away. The
expected return of the asset is only based on its systematic risk, so we should use beta
instead of standard deviation as the measure of risk. (1 mark)

14

Question 4 (10 Marks)

a) Explain how a trader could use forward rates to earn a profit in the foreign exchange
market.
(4 marks)

A forward contract enables the trader to buy/sell currencies at a pre-determined exchange

rate. (1 mark)
If the forward exchange rate is different from the spot exchange rate, the trader can enter
into a forward contract as the buyer/seller of a currency to earn a determined return. (1
mark)
The annualised return is:
Forward premium/discount=(forward rate-spot rate)/spot rate*(360/90) (2 marks)

b) Describe the process of International Capital Budgeting.

Describe three factors and difficulties other than exchange rate risk that need to be
taken into account in the decision-making process for evaluating overseas capital
projects?
(6 marks)

Most companies find it more difficult to estimate the incremental cash flows for foreign
projects. (2 marks)
Problems with cash flows can arise when foreign governments restrict the amount of cash
that can be repatriated, or returned, to the parent company. (2 marks)
Country risk: If a company is located in a country with a relatively unstable political
environment, management will require a higher rate of return on capital projects as
compensation for the additional risk. (2 marks)
o Nationalisation
o Changes in tax laws
o Tarriffs and quotas on imports
(Up to 4 marks can be given if the students only focus on the discussion of country risk)

15

Question 5 (10 Marks)

Grace Kang Ltd sells jigsaw puzzles for $50 per puzzle. With the current production
technology, the total fixed costs are $17,500,000 per annum, and the depreciation and
amortisation for the company is $5,000,000. It costs $10 to produce one puzzle and the
forecast sales next year will be 1,500,000 units.
The company is considering changing its production technology. Sales are expected to be
the same regardless of which production technology the company chooses. However, if a
new production line is adopted, the fixed costs will increase to $20,000,000, and the variable
cost per unit will be reduced to $7 per puzzle. Assume the depreciation and amortisation
expense is unchanged.
a) Use the above information to calculate the accounting DOL for the current technology
as well as the new technology.
(4 Marks)
DOL=1+(FC+D&A)/EBIT, EBIT=revenue-FC-VC-D&A
EBIT_1=50*1.5m-17.5m-10*1.5m-5m=37.5m
DOL_1=1+(17.5m+5m)/37.5m=1.6
EBIT_2=50*1.5m-20m-7*1.5m-5m=39.6m
DOL_2=1+(20m+5m)/39.5m=1.6329

b) Which technology has a higher accounting DOL? Compare the two technologies and
explain why that is the case.
(2 Marks)
The new production technology. Since it has a higher proportion of fixed cost, the accounting profits
should be more sensitive to changes in revenue.

16

c) Calculate the EBIT break-even points for both technologies.

(2 Marks)

EBIT breakeven=(FC+D&A)/(price-unit VC)

Breakeven_1=(17.5m+5m)/(50-10)=562,500
Breakeven_2=(20m+5m)/(50-7)=581,395

d) What is the number of puzzles for which the cash flow operating profit is the same,
regardless of the technology choice? Calculate the crossover level of unit sales for
EBITDA.
(2 Marks)

CO(EBITDA)=(FC_1-FC_2)/(UV_1-UC_2)
=(20m-17.5m)/((50-7)-(50-10))
=833,333

17

Rough Working Paper

18