BFC2140 CORPORATE FINANCE
PRACTICE QUESTIONS FOR FINAL EXAM
Important Notice:
Do NOT start your revision by solving the practice exam. Start your revision with tutorial
questions, lecture notes, and the textbook.
Any questions presented in this paper are for the purpose of revision only. These questions
provide you with an idea about the sort of questions that could be asked. While we made every
effort to design the practice exam similarly to the actual one, it does not perfectly reflect the
structure of the real exam. For example, each question here may have more sub-parts (or fewer
sub-parts) than a question of the real final exam. Refer to the FAQ document for information
on the structure of the real exam. Monash policy requires that the content (i.e., the questions)
of the real exam must be different from this set of questions.
Numerical-answer questions (Section B of the Exam) are designed such that you can type your
final answer in pure numeric format. Do NOT use %/$ signs, commas or spaces (e.g. only
enter 10 if it is 10 days/$10/10%)
Essay-typed questions (Section C of the Exam) are designed such that you can type your
answers in a linear line using simple notations of linear algebra such as “*” for multiplication,
“/” for division, “^” for power, “exp( )” for exponential, etc. For example: Re = Ru + D/E(Ru
- Rd), and then plug in the numbers, e.g. Re = 10%+2/3*(10%-8%) =11.33%. Note that essay
questions will usually include multiple sub-parts, so make sure you indicate each part within
the one text-box provided (e.g. a. AAA b. BBB c. CCC).
Finally, make sure you attempt these questions under the same conditions you’ll get in the
actual exam, e.g. not using any notes but the formula sheet, and using only a virtual calculator.
SECTION A: 5 MULTIPLE-CHOICE QUESTIONS
Question 1:
Andjelkovic-Stewart Limited Company borrows $1 million short-term, $10,000 long-term and
invests these proceeds in inventory. Which of the following statement is TRUE?
A. Increase in working capital
B. No change in working capital
C. Decrease in working capital
D. No change in working capital and no change in cash.
Question 2
Which of the following is a reason why incremental earnings may be different from incremental
cash flows?
A. Changes in accounts receivable reflects non-cash sales present in incremental earnings that
are not incremental cash flows.
B. Depreciation is a cash expense, but does not appear in incremental earnings.
C. Capital expenditures appear on the income statement. However, as these costs are
depreciated over time, they should not be present in incremental cash flows.
D. Firms pay taxes based on incremental cash flows, not incremental earnings.
Question 3
In order to use the WACC to evaluate a future project's flows, which of the following must
hold?
A. The project will be financed with the same proportion of debt and equity as the company.
B. The systematic risk of the project is the same as the overall systematic risk of the company.
C. The project must be viable.
D. A and B above.
Question 4
According to M&M Proposition 2, the cost of a company's equity
A. increases with the debt-to-equity ratio.
B. decreases with the debt-to-equity ratio.
C. increases and then falls with the debt-to-equity ratio.
D. decreases and then increases with the debt-to-equity ratio.
Question 5
Which of the following investments offers the lowest level of risk in general?
A. small stocks
B. Treasury bills
C. S&P 500
D. corporate bonds
SECTION B: 5 NUMERICAL-ANSWER QUESTIONS
Question 6:
You are given the following variance – covariance matrix on two shares and the market
portfolio. Risk free rate is 6% per annum. Expected market return is 14% per annum. You have
$500,000 available to invest. Assume that you are forming a portfolio by investing $200,000
in Share A, $200,000 in Share B and the balance of the $500,000 in risk free asset. What is the
standard deviation of this portfolio in percentage terms?
[Type only the final answer into the response box below (NOT into the Notes box) and in pure
numeric format. Do NOT use %/$ signs, commas or spaces (e.g. only enter 10 if it is 10
days/$10/10%)]
ANSWER:
Question 7
The Fast Reader Company supplies bulletin board services to numerous hotel chains
nationwide. The owner of the firm is investigating the desirability of employing a billing firm
to do her billing and collections. Because the billing firm specialises in these services,
collection float will be reduced by 25 days. Average daily collections are $12,000 and the
owner can earn 9% annually (expressed as an APR with monthly compounding) on her
investments. If the billing firm charges $475 per month, what is the value today of the billing
firm's charges?
[Type only the final answer into the response box below (NOT into the Notes box) and in pure
numeric format. Do NOT use %/$ signs, commas or spaces (e.g. only enter 10 if it is 10
days/$10/10%)]
ANSWER:
Question 8
Al Corporation plans to finance a new investment with leverage. It plans to borrow $56 million
to finance the new investment. The firm will pay interest only on this loan each year, and it will
maintain an outstanding balance of $56 million on the loan. After making the investment, the
firm expects to earn annual free cash flows of $12 million. However, due to reduced sales and
other financial distress costs, the firm's expected annual free cash flows will decline to $11
million. The firm currently has 5.7 million shares outstanding, and it has no other assets or
opportunities. Assume that the unlevered discount rate for the firm's future free cash flows is
8.9% and the firm's corporate tax rate is 30%. What is the firm's share price today?
[Type only the final answer into the response box below (NOT into the Notes box) and in pure
numeric format. Do NOT use %/$ signs, commas or spaces (e.g. only enter 10 if it is 10
days/$10/10%)]
ANSWER:
Question 9
Wernham-Mifflin is considering launching a new line of pentagonal-shaped paper. You have
the following information:
• Revenues due to the sale of the new product are expected to be $90 million annually.
• Total paper production costs will increase from the current level of $22 million annually to
$63 million annually after the product launch.
• Top sales agent Michael Scarn will be reassigned from other projects to sell the new product
line. Sales of those other products are expected to decline by $12 million annually.
• The project will make use of an existing paper mill, built last year at a cost of $38 million.
The mill is being depreciated using prime cost over a useful life of 16 years.
• Wernham-Mifflin currently pays taxes at a marginal rate of 26%.
• Total annual incremental cash flows for the project are expected to remain constant for the
next 16 years. After this period, the project’s total incremental cash flows will decline at a
rate of 5% annually and will be received in perpetuity.
What is the present value of the project in millions of dollars if the annual project discount rate
is 6.0%?
[Type only the final answer into the response box below (NOT into the Notes box) and in pure
numeric format. Do NOT use %/$ signs, commas or spaces (e.g. only enter 10 if it is 10
days/$10/10%)]
ANSWER:
2015 2016 2017
$56.70 $69.60 $61.80
Question 10
A firm expects a project to have the following incremental Income Statement (all values in
millions of dollars):
Fiscal year
Revenues
Costs -34.8 -42.7 -37.9
Depreciation -1.9 -1.9 -1.9
EBIT 20 25 22
The project’s incremental pro-forma balance sheet is expected to contain the following working
capital items at the end of those fiscal years (all values in millions of dollars):
Assets Liabilities
Fiscal year 2015
Inventories $2.80 Accounts payable $2.00
Accounts receivable $1.30
Fiscal year 2016
Inventories $3.50 Accounts payable $2.50
Accounts receivable $1.60
Fiscal year 2017
Inventories $3.10 Accounts payable $2.20
Accounts receivable $1.40
In 2016, expected incremental capital expenditures total $2.9 million and incremental after tax
salvage is expected to be $5.0 million. The tax rate for the project is 30%. What are the expected
incremental cash flows in millions of dollars from the project in 2016?
[Type only the final answer into the response box below (NOT into the Notes box) and in pure
numeric format. Do NOT use %/$ signs, commas or spaces (e.g. only enter 10 if it is 10
days/$10/10%)]
ANSWER:
SECTION C: 5 ESSAY-TYPED QUESTIONS
Question 11
You are considering two identical firms one levered the other not. Both firms have expected
EBIT of $600. The value of the unlevered firm (vU) is $2000. The corporate tax rate (t) is 30%.
The cost of debt (rD) is 10%, and the ratio of debt to equity (D/E) is 1 for the levered firm.
(a) Calculate the cost of equity for both the levered (rL) and unlevered firms (rU).
(b) Calculate the weighted average cost of capital for each firm.
(c) Why is the cost of equity higher for the levered firm, but the WACC lower?
(d) In an MM world without taxes, what is the optimal capital structure?
Question 12
Floorstreet Stock Raiders Incorporated (FSR) has the following capital structure: Debt 25%,
Preferred Stock 15%, Common Equity 60%. FSR’s beta is 1.5. FSR’s expected net income this
year is $34,285.72, its established dividend payout ratio is 30 percent, its corporate tax rate is
40 percent, and investors expect earnings and dividends to grow at a constant rate of 9 percent
in the future. FSR paid a dividend of $3.60 per share on its 76,000 issued ordinary shares. The
Treasury note rate is 4.3% and the market risk premium is 8%. FSR can obtain new capital in
the following ways:
+ Preferred: Issue 10,800 new preference shares committing FSR’s to a dividend of $11. The
preference shares can be sold to the public at a price of $95 per share.
+ Debt: Issue 1,800 ten year $1,000 par value bonds to the public. The bonds will pay 11.115%
coupons (annually) and have a current yield to maturity of 12%. a. What is the firm’s cost of
debt?
b. What is the firm’s cost of preferred equity?
c. What is the firm’s cost of ordinary equity?
d. What is the firm’s overall cost of capital?
e. The following investment opportunities have the same level of risk with FSR. Which projects
should FSR accept? Why?

Question 13
Mick Ronalds is a fast-food establishment that is considering replacing its fryolators. The cost
of the new plant is $200,000. For tax purposes, depreciation is allowed at 20% on prime cost
(this means, straight line over the next five years). The plant would be sold for $40,000 at the
end of its ten-year life.
Operating expenses will be $90,000 per annum, compared with $120,000 a year for the existing
fryolators. However, if the existing plant were kept, $70,000 would need to be spent in four
years’ time on maintenance, which would be immediately expensed for tax purposes. The
existing plant is being depreciated at $6,000 a year. It now has a book value of $60,000. This
plant could be sold today for $50,000. Alternatively, it could be used for the next ten years and
then scrapped for nil value.
The tax rate is 30%. Mick Ronald’s equity beta is 1.00, the pre-tax cost of debt is 20% and the
risk free rate and market return are 6% and 14%, respectively. Mick Ronald’s debt to equity
ratio is 1.
a. What is the firm’s overall cost of capital?
b. What is the firm’s initial investment?
c. What is the firm’s operating cash flow in year 1?
d. What is the firm’s operating cash flow in year 4?
e. What is the firm’s operating cash flow in year 6?
f. What is the firm’s terminal cash flow?
Question 14
It is the beginning of September and you have been offered the following deal to go heli-skiing.
If you pick the first week in January and pay for your vacation now (i.e. make a booking four
months ahead), you can get a week of heli-skiing for $2500. However, if you cannot ski because
the helicopters cannot fly due to bad weather, there is no snow, or you get sick, you do not get
a refund. There is a 40% probability that you will not be able to ski. If you wait until the last
minute and go only if you know that the conditions are perfect and you are healthy, the vacation
will cost $4000. You estimate that the pleasure you get from heli-skiing is worth $6000 per
week to you (if you had to pay any more than that, you would choose not to go). Assume your
effective annual cost of capital is 8%, i.e. EAR = 8%, should you book ahead or wait?
Question 15
What is the relationship between the covariance and the correlation coefficient?