FINA2006 Principles of Finance
Part A – Multiple Choice Questions
Select the most appropriate option for each question below.
1. Investors require a 4 percent return on risk – free investments. On a particularly risky investment, investors require an excess return of 7 percent in addition to the risk – free rate of 4 percent. What is this excess return called?
- Inflation premium
- Required return
- Real return
- Average return
- Risk premium
2. Systematic risk is:
- totally eliminated when a portfolio is fully diversified.
- defined as the total risk associated with surprise events.
- the risk that affects a limited number of securities.
- measured by beta.
- measured by standard deviation.
3. Capital budgeting includes the evaluation of which of the following?
- Size of future cash flows only
- Size and timing of future cash flows only
- Timing and risk of future cash flows only
- Risk and size of future cash flows only
- Size, timing, and risk of future cash flows
4. Which one of the following best matches the primary goal of financial management?
- Increasing the dollar amount of each sale
- Increasing traffic flow within the firm’s stores
- Transforming fixed costs into variable costs
- Increasing the firm’s liquidity
- Increasing the market value of the firm
5. A credit card has an annual percentage rate of 12.9 percent and charges interest monthly. The effective annual rate on this account:
- will be less than 12.9 percent.
- can either be less than or equal to 12.9 percent.
- is 12.9 percent
- can either be greater than or equal to 12.9 percent.
- will be greater than 12.9 percent.
6. The beta of Gru Pty. Ltd. is estimated to be 1.5. The market risk premium is currently estimated to be 7.2 percent and the yield on government securities bonds is 5.5 percent. What is the cost of equity capital for Gru Pty? Ltd.?
- 15.45 percent
- 16.30 percent
- 8.05 percent
- 19.05 percent
- 10.10 percent
7. Which one of the following defines the internal rate of return for a project?
- The discount rate that creates a zero cash flow from assets
- The discount rate that results in a zero net present value for the project
- The discount rate that results in a net present value equal to the project’s initial cost
- The rate of return required by the project’s investors
- The project’s current market rate of return
8. What is the approximate payback period for a project with the following cash flows?
- 2.56 years
- 2.89 years
- 3.17 years
- 3.74 years
9. The shareholders of Innovative Technologies Ltd (ITL) have invested a total of $3 million and require a return of 15 percent. The debtholders of ITL have invested $20 million and charge an interest rate of 9 percent. Which of the following is the total return required by the company’s capital providers?
10. Which of the following is not a method for raising additional capital?
- A share buy-back
- A private placement
- A dividend reinvestment plan
- A rights issue
- An initial public offering (IPO)
Part B -True / False Questions
True / False: Record the most appropriate solution (either true [T] or false [F]) from the given statement below.
- The time value of money concept says that a dollar to be received in the future is worth more than a dollar received today.
- The effective rate of interest decreases as the compounding frequency increases.
- The present value of an annuity due is always less than the present value of an otherwise identical ordinary annuity.
- If two stocks are perfectly positively correlated, then an increase in one of 10% will be associated with a decrease in the other of 10%.
- An individual’s average tax rate will always be lower than their marginal tax rate (other than below any nil tax threshold) due to the graduated scale of personal tax rates.
- According to the pecking order theory, external funding is used to fund new projects after internal funding is exhausted.
Part C – Short Answer Questions
At the beginning of 1972, a relative of yours migrated to Australia with $10,000 ‘spare cash’. The money could have been used to buy a block of land or invested in an ‘at – call’ savings account that paid interest at an annual percentage rate of 8% p.a. compounded half – yearly. At the end of 2014, the land was valued by a local real estate agent who was keen to list the property on behalf of his agency, at a price of approximately $400,000.
- Which of the alternative investments (land/savings account) had a higher value at the end of 2014? Justify your response with appropriate calculations.
- Assuming the half – yearly compounding of interest, what was the rate of growth in the land value over the total period expressed as a nominal interest rate?
- What was the rate of growth in the land value over the total period expressed as an effective interest rate?
- What investment in the savings account would have been necessary at the beginning of 1972, to have the same value as the land was worth at the end of 2014? Briefly explain your response.
a) The following table shows the probabilities of all possible economic conditions next year, along with the associated returns on security under each market condition.
Calculate the expected return and standard deviation of returns on the security.
b) You form a portfolio by investing $10,000 in each of Stocks ABC and XYZ. Security A has a standard deviation of returns equal to 12%, whereas security B’s standard deviation of returns is 8%.
If the returns on A and B are uncorrelated, what is the standard deviation of your portfolio?
Bibo Ltd plans to purchase a new delivery truck for $56 000. The truck will be depreciated using the straight-line method based on an estimated useful life of 5 years and a salvage value of $6 000 at the end of the fifth year. The expected annual cash inflows generated from this investment are $15 500, $14 000, $16 500, $15 000, and $13 000. The increased cash inflow in Year 3 resulted from an overhaul costing $3 500 at the end of Year 2. The company uses a discount rate of 10%.
- Determine whether XYZ should purchase the truck based on net present value (NPV) of the truck
- Discuss whether Bibo Ltd should purchase the truck based on the payback period (PP) with reference to the advantages and disadvantages of PP compared to the NPV method. Assume the company’s standard payback period is 4 years.
Industrial Ltd is an all-equity company with total ordinary share value worth $40 million. The company’s management plans to change its capital structure to $20 million equity and $20 million debts. The company’s costs of equity and debts are 12% and 8%, respectively. A corporate tax rate of 30% applies to Industrial Ltd.
- Calculate the company’s after-tax cost of capital in two scenarios: 1) all – equity financing and 2) debt-equity financing.
- Briefly comment on the results in Part (a).
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