FINM7409 Financial Management for Decision Makers
Final Exam, Semester 1, 2022
Exam duration: 2 hours + 10 minutes reading + 15 minutes submission
Instructions:
Once you have completed the exam, upload the completed exam answers file in
ONE PDF document to the Blackboard assignment submission link.
You may choose to either type your response OR hand write and scan-to-pdf
your response.
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Problem 1 (8 marks)
Part A (2 marks)
What is the present value of the following cash flow to be received?
a. $2000 received in 5 years at 10% compounded annually
b. $5000 received in 10 years at 5% compounded semi-annually
Solution
a. = $2,000(1+10%)5 = $1,241.84
b. = $5,000(1+5%/2)20 = $3,051.36
Part B (2 marks)
After researching various term deposit products, you have found that you can deposit your
money in either Commonwealth Bank or Westpac Bank. Commonwealth Bank is offering a
deposit rate of 10.5% compounded monthly, while Westpac Bank is offering 11%
compounded quarterly. Which bank offers the better rate?
Solution:
= �1 + 10.5%12 �12 − 1 = 11.02%
= �1 + 11%2 �2 − 1 = 11.30%
Westpac bank offers the better rate.
Part C (2 marks)
You would like to have $100,000 in 10 years’ time. To achieve your target, you plan to invest
equal amount of money each year in the stock market. Assume the return from the stock
market is 10% per year. Your first payment will be made immediately. How much should
you invest annually?
Solution:
=
((1 + ) − 1) =
10%
((1 + 10%)11 − 1) = 100,000
= 5396.31
Part D (2 marks)
Ten years ago, you took out a $300,000, 30-year mortgage loan to finance your house
purchase. The interest is 6%, compounded monthly, and the monthly payment is $1,800.
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What is the outstanding balance on your current loan immediately after you make the 120th
payment?
Solution:
=
× �1 − 1(1 + )� = 18000.5% × �1 − 1(1 + 0.5%)240� = $251,245.4
Problem 2 (10 marks)
Part A (6 marks)
As a graduate accountant, you are asked by your manager to evaluate two investment
projects. Both projects concern the purchase of new machinery. The follow data are available
for each project.
A ($) B ($)
Cost of machine 100,000 75,000
Expected profit before
depreciation & tax
Year 1 50,000 25,000
Year 2 50,000 35,000
Year 3 30,000 35,000
Year 4 20,000 35,000
Estimated residual value at
the end of Year 4
20,000 15,000
Assume the required rate of return for both projects are 10%, and straight-line depreciation is
used. The company tax rate is 30%.
a. Calculate Accounting Rate of Return for both projects
b. Calculate the payback period for both projects
Solution:
A ($) B ($)
Depreciatio
n
100,000 − 20,0004 = 20,000 75,000 − 15,0004 = 15,000
Avg profit
b/f tax
50,000 + 50,000 + 30,000 + 20,0004
− 20,000 = 17,500 25,000 + 35,000 + 35,000 + 35,0004− 15,000 = 17,500
Avg profit
a/f tax
17,500(1 − 30%) = 12,250 17,500(1 − 30%) = 12,250
Avg
Investment
100,000 + 20,0002 = 60,000 75,000 + 15,0002 = 45,000
ARR 12,25060,000 = 20.42% 12,25045,000 = 27.22%
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Net cash flow (a/f tax) A ($) B ($)
Cost of machine -100,000 -75,000
Year 1 50,000-(50,000-
20,000)*0.3=41,000
25,000-(25,000-
15,000)*0.3=22,000
Year 2 41,000 35,000-(35,000-
15,000)*0.3=29,000
Year 3 30,000-(30,000-
20,000)*0.3=27,000
29,000
Year 4 20,000 29,000
End of year 4 20,000 15,000
PP 2 + 18,00027,000 = 2.67 2 + 2400029000 = 2.83
Part B (4 marks)
As the investment manager, you are evaluating two mutually exclusive projects. Both
projects require the same initial investment of $20 million. The first investment will generate
$4 million per year in perpetuity. The second investment will generate $3 million at the end
of the first year and its revenues will grow at 3% per year thereafter. The cash flows of both
projects start at the end of the first year.
a. Calculate the IRRs for both projects?
b. Calculate the NPVs for both projects, assume the cost of capital is 6%?
c. Given your answer to a) and b), which project should you choose and why?
Solution:
a. 20 = 4
1
1 = 20% 20 = 3
2−3%
2 = 18%
b. 1 = −20 + 46% = 46.7
2 = −20 + 36% − 3% = 80
c. Choose second project, as it is mutually exclusive investments.
Problem 3 (12 marks)
Part A (2 marks)
What is the relationship between yield to maturity and the value of a bond?
Solution:
Assume all else constant, a higher YTM results in lower bond value.
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Part B (2 marks)
There are two types of return from investing in ordinary shares. What are they?
Solution:
Capital gain and dividend income.
Part C (2 marks)
AAC Ltd issued a 90-day bank bill 30 days ago. The face value of the bill is $100,000. If the
current market yield on this bill is 4% per annum, what is the price of the bill today?
Solution:
= 100,0001 + 4% × 60365 = $99,346
Part D (3 marks)
Altus Investment Ltd has just bought a bond with 10-year maturity and a face value of $100.
The coupon rate is 6%, paid annually. Assume the required yield to maturity is 6%. A year
later, Altus sold the bond when the yield to maturity is 5%. What is the return on this
investment?
Solution:
= 100 ∗ 6% = 6
0 = 66% × �1 − 1(1 + 6%)10� + 100(1 + 6%)10 = $100
1 = 65% × �1 − 1(1 + 5%)9� + 100(1 + 5%)9 = $107.11
= 107.11 + 6100 − 1 = 13.11%
Part E (3 marks)
Sydney Train’s share price was $10 when the company announced that it will cut next year’s
dividend to $0.6 per share from $1 (the dividend just paid). It will use the savings to expand
its network, and as a result, the growth in dividend is expected to accelerate to 7% from
current value of 4%. How do you think the announcement will affect Sydney Train’s share
price? Hint: you need to calculate the new share price.
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Solution: $10 = 1 × (1 + 4%)
− 4%
= 14.4%
= 0.614.4%− 7% = $8.11
Problem 4 (10 marks)
Part A (2 marks)
CSL Ltd has a beta of 0.80. If the expected market return is 10% and the risk-free rate is 4%,
what is the expected return for CSL Ltd according to CAPM?
Solution:
= 4% + 0.8 × (10% − 4%) = 8.8%
Part B (2 marks)
Portfolio diversification effect depends on both the volatility of the individual stocks in the
portfolio and the correlations among those stocks. Is this statement correct? Explain your
answer.
Solution:
No, diversification effect only depends on the correlation, not the individual volatility as
individual volatility will be averaged out in large portfolio.
Part C (4 marks)
You are evaluating an investment in a portfolio comprising two firms’ ordinary shares. You
have collected the following information about the ordinary shares in BHP and Rio Tinto
(both are large mining companies):
Expected Return Standard Deviation
BHP 0.15 0.2
Rio Tinto 0.18 0.24
Correlation coefficient 0.8
a. If you invest equal amount of money in these two firms, what is the expected return
and the standard deviation of the portfolio?
b. What will be the standard deviation of the portfolio if the correlation coefficient
becomes 0.3? Compared to (a), how should you change your investment strategy?
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Solution:
a. �� = 0.5 ∗ 15% + 0.5 ∗ 18% = 16.5%
= �0.5 ∗ 0.22 + 0.5 ∗ 0.242 + 2 ∗ 0.5 ∗ 0.5 ∗ 0.2 ∗ 0.24 ∗ 0.8 = 26.08%
b. = √0.5 ∗ 0.22 + 0.5 ∗ 0.242 + 2 ∗ 0.5 ∗ 0.5 ∗ 0.2 ∗ 0.24 ∗ 0.3 = 23.66%
You should try to diversify across industries to have lower correlation among stocks
in your portfolio.
Part D (2 marks)
BP Oil Ltd has a beta of 1.2 and an expected return of 11%. A risk-free asset currently earns
4%.
a. What is the expected return on a portfolio that is equally invested in the two assets?
b. If a portfolio of the two assets has a beta of 0.8, what are the portfolio weights?
Solution:
= 0.5 × 11% + 0.5 × 4% = 7.5% 0.8 = 1.2 × + 0 × �1 − �
= 66.67%, = 33.33%
Problem 5 (10 marks)
Part A (2 marks)
Based on the most recent balance sheet, Susan identifies the total debt for the company is
$8m million. The total interest payment for the coming year will be about $1 million. Susan
then argues that “We owe $8 million, and we will pay $1 million interest. Therefore, our cost
of debt is 12.5% ($1 million/$8 million)”. What’s wrong with this conclusion?
Solution:
Interest expense is tax deductible, so the actual cost of debt is lower.
Other answers can be correct, e.g., $8mil may not be the market value of debt.
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Part B (4 marks)
Brookfield Railway Ltd has the following securities outstanding:
• Corporate bond: 20,000, 5.0% coupon bonds outstanding, at $1,000 face value, with
15 years to maturity. The bond is currently trading at par value.
• Ordinary shares: 1,000,000 ordinary shares selling for $50 per share. The share will
pay a dividend of $3 next year. The dividend is expected to growth by 4% per year
indefinitely.
• Preference shares: 125,000, 6% preference shares (face value of $100) selling at $80
per shares.
Assume tax rate is 30%.
Calculate the WACC for Brookfield Railway Ltd.
Solution:
= 1,000,000 × $50 = $50
= 20000 × $1000 = $20
= 125,000 × $80 = $10
= 5% $50 = $3
−4%
, = 10%
$100×6%
= $80, = 7.5%
= 50
80
× 10% + 2080 × 5% × (1 − 30%) + 1080 × 7.5% = 8.06%
Part C (2 marks)
Modigliani and Miller capital structure theorem states that firm value is not affected by the
capital structure. But in reality, why do managers care a great deal about capital structure?
List two reasons and explain.
Solution:
First, capital market is not perfect, e.g., transaction cost, personal borrowing limit
Second, capital structure affects firm cash flow, e.g., direct/indirect bankruptcy costs, tax
Part D (2 marks)
Lunas Ltd currently has no debt outstanding, and is entirely financed by $1 million of equity.
The company is considering refinancing and issuing $0.5 million of debt to buy back
ordinary shares. The debt has 30-year maturity with an interest rate of 5% per year. Lunas
currently has a dividend payout ratio of 100% and will maintain this rate into the future. The
current income statement Lunas Ltd is presented below. Assume corporate tax rate is 30%.
Earnings before interest and tax (EBIT) $100,000
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Less: Interest expense 0
Equals: Profit before tax $100,000
Less: Tax ($30,000)
Equals: Net profit $70,000
a. When the transaction is completed, how much money can Lunas Ltd distribute to
equityholders and debtholders next year if EBIT remains unchanged?
b. What is Lunas Ltd’s interest tax shield from the issuance of the debt?
Solution:
a.
Earnings before interest and tax (EBIT) $100,000
Less: Interest expense $25,000
Equals: Profit before tax $75,000
Less: Tax ($22,500)
Equals: Net profit (dividend) $52,500
Interest payment $25,000
Total payment $77,500
b.
Interest tax shield=77,500-70,000=7,500
Or 25,000*30%=7,500