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Corporate Finance Sample FINAL EXAM

Corporate Finance 2 (University of Lethbridge)

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MGT3470 Corporate Finance, Practice Exam (Part I)

Answer Key

Section I: Multiple Choice Questions.

Circle ONE best answer for each question.

1. The designated source(s) of external financing required to make the pro forma balance
sheet balance is called the
A) Retained earnings
B) Plug variable
C) Common stock account
D) Cash flow variable
E) Debt-to-equity ratio

2. Why is it important to determine if a firm is operating at full capacity or not?

A) Because a firm that is operating at less than full capacity will not need any external
financing.
B) Because in a firm that is operating at less than full capacity, fixed assets will typically
increase at the same percent as sales.
C) Because a firm with excess capacity has some room to expand sales without
increasing the investment in fixed assets.
D) Because, for a given increase in sales, firms operating at less than full capacity will
experience more rapid asset growth than firms that do operate at full capacity.
E) Because only firms operating at full capacity can grow rapidly and sustainably.

3. Diversifiable risk is the risk that:

A) Affects almost every financial asset that is sold in the marketplace.
B) Relates to the overall economy, such as inflation and GDP growth.
C) Is caused by an event that affects only a limited number of assets.
D) Serves as the basis for determining the amount of the risk premium.
E) Is generated by expected news.

4. Over the past 50 years, which of the following investments has provided the smallest
average risk premium?
A) Canadian common stocks.
B) U.S. common stocks.
C) Treasury bills.
D) Canadian Long bonds.
E) Canadian small stocks.

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5. One year ago, Yoko purchased 100 shares of stock for $3,896. Since that time, he has
received a total of $180 in dividends. If he sells the stock at today's market price he will
realize a total return on his investment of 10.37%. Assuming he sells the stock today,
what is the dollar amount of his capital gain per share of stock?
A) $1.80
B) $2.24
C) $3.68
D) $4.04
E) $5.84

6. Your firm is considering a project which requires an initial investment of $5 million.

Your target D/E ratio is 0.67. Flotation costs for equity are 8% and flotation costs for debt
are 2%. What is the true cost (in dollars) of the project when you consider flotation costs?
A) $5.00 million
B) $5.26 million
C) $5.30 million
D) $5.59 million
E) $5.61 million

7. An unlevered firm has 10,000 shares outstanding. The firm can borrow $40,000 at 6% to
buyback half of its shares without altering existing share price. What is the firm’s break-
even EBIT if there are no corporate or personal taxes?
A) $600
B) $2,400
C) $3,600
D) $4,800
E) None of the above

8. Which of the following is true about the WACC?

A) The optimal capital structure is the one that maximizes the WACC.
B) The value of the firm will be maximized when the WACC is minimized.
C) The WACC is the appropriate discount rate for all new projects of the firm.
D) The WACC is impossible to calculate for a firm with multiple divisions.
E) Since discount rates and firm value move in the same direction, minimizing the
WACC will minimize the value of the firm.

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9. Which of the following statements is/are true regarding corporate borrowing when EBIT
is positive?
A) Increasing financial leverage increases the sensitivity of EPS and ROE to changes in
EBIT.
B) Increasing financial leverage decreases the sensitivity of EPS and ROE to changes in
EBIT.
C) Leverage is favourable when EBIT is relatively low and unfavourable when EBIT is
relatively high.
D) Leverage is favourable when EPS is relatively high and unfavourable when EPS is
relatively low.
D) High leverage decreases the returns to shareholders (as measured by ROE).

10. ABC Company’s debt/equity=0, its cost of equity is 10.8% and it can borrow at 8%. If
there are no taxes, what will be the cost of equity if ABC changes its debt/equity to 0.5?
A) 10.8%
B) 11.2%
C) 12.2%
D) 14.4%
E) 18.8%

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Section II: Short-answer / Calculation Questions

Question #1

Part 1.A

ABC Limited (ABC) is a boutique men’s fashion house, specializing in affordable fashion-forward
separates, with its own production facility. ABC is a growing firm and its financial managers
predict that it will need external financing to fuel its growth. The company’s most recent financial
statements are provided below. Using the percentage of sales approach, construct ABC’s 2014
Pro Forma Balance Sheet based on the following information. How much is ABC’s external
financial need (EFN)?
 The company is operating at 100% capacity;
 The forecasted growth in sales is 18% for 2014;
 The firm has a dividend policy to pay out 30% of Net Income to its shareholders as cash
dividends, and keep the remaining 70% as retained earnings;

Year 2013 % of Sales

Sales 74,889 100.0%
Costs excluding Depreciation - 58,413 -78.0%
EBITDA 16,476
Depreciation - 5,492 -7.3%
EBIT 10,984
Interest Expense - 306
Pretax Income 10,678
Income Tax (35%) - 3,737
Net Income 6,941

Year 2013 % of Sales

Cash and Equivalents 11,982 16.0%
Accounts Receivable 14,229 19.0%
Inventories 14,978 20.0%
Total Current Assets 41,189 55.0%
PP&E 49,427 66.0%
Total Assets 90,616
Accounts Payable 11,982 16.0%
Long-term Debt 4,500
Total Liabilities 16,482
Stockholders' Equity 74,134
Total Liabilities & Equity 90,616

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Answer Key:

This is the same as the BJI example used in Week 4 Lecture.

Total Assets (funds needed) = $106,927

Total Liabilities & Shareholders’ Equity (funds available) = $98,531
EFN = $106,927 - $98,531 = $8,396

Part 1.B

Discuss why it is important for managers to understand the importance of both the internal growth
rate and the sustainable rate of growth?

Answer Key:

One reason that causes firms to go out of business is the lack of sufficient external funding to
support the growth of the firm. Likewise, too much growth may not be supported by available
external funding and, in turn, may hurt the firm. Internal growth rate is the maximum growth
without any external funding, while sustainable growth rate is the maximum growth sustainable
with only additional debt funding (equity naturally rises because of retained earnings).
Understanding the implications of both the internal and sustainable growth rates can help
management know when to limit firm growth such that the growth does not exceed the availability
of the necessary financing to fund that growth. When a firm is growing too fast, it will likely to run
into financial trouble in the future.

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Question #2

Part 2.A

What is the expected rate of return for a portfolio that is comprised of $90,000 invested in
stock S and $60,000 in stock T?

Answer Key:

E(r)Boom = [$90,000/($90,000 + $60,000) *0.11)] + [$60,000/($90,000 + $60,000) *0.05) =

0.066 + 0.02 = 0.086
E(r)Normal = [$90,000/($90,000 + $60,000) *0.08)] + [$60,000/($90,000 + $60,000) *0.06)
=0 .048 +0 .024 =0 .072
E(r)Bust =[$90,000/($90,000 + $60,000) * -0.05)] + [$60,000/($90,000 + $06,000) *0.08) = -
0.03 + 0.032 =0 .002
E(r)Portfolio = (0.05 *0.086) + (0.85 *0.072) + (0.10 *0.002) = 0.0043 + 0.0612 + 0.0002 =
0.0657 = 6.57%

Part 2.B

You have a $15,000 portfolio which is invested in stocks A and B plus a risk-free asset. $3,000 is
invested in stock A. Stock A has a beta of 1.7 and stock B has a beta of 1.3. Approximately how
much (in dollar terms) needs to be invested in stock B if you want your portfolio’s beta to equal
that of the overall market?

Answer Key:

Portfolio Beta = weighted average sum of betas. Risk-free asset’s beta = 0.0, and market beta =
1.0.

Beta, portfolio = 1.0 = (3000/15000)*1.7 + (x/15000)*1.3 + ((15000 – 3000 - x)/15000)*0.0

 15000 = 5100 + 1.3x =  x = (15000 – 5100) / 1.3 = $7,615.38

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Question #3

Part 3.A

GT Industries has 6.5 million shares of common stock outstanding with a market price of $14 per
share. The company also has outstanding preferred stock with a market value of $10 million, and
25,000 corporate bonds outstanding each with face value $1,000 and selling at 90% of face value
on the bond market. The cost of equity is 14%, the cost of preferred is 10%, and the pre-tax cost
of debt is 7.25%. GT's marginal corporate tax rate is 30%. What are the respective market-
value weights for GT’s common stock, preferred stock, and corporate bonds? What is the
firm’s WACC?

Answer Key:

Market value of common stock = 6.5 mil * $14 = $91.0 million (E/V = 0.7368)
Market value of preferred = $10 million (P/V = 0.0810)
Market value of debt = 25,000 * ($1000 * 90%) = $22.5 million (D/V = 0.1822)
Market value of the firm = $123.5 million
WACC = 14%*0.7368 + 10%*0.0810 + 7.25%*(1-0.30)*0.1822 = 12.05%

Part 3.B

XYZ has an expected perpetual EBIT = $4,000. The firm is currently unlevered with 20,000 shares
of outstanding, and its cost of equity is 15%. The firm is considering to restructure its funding
sources by borrowing $10,000 perpetual debt and buying back some of its shares. The cost of debt
is 10% and the firm will pay interest annually. The company’s marginal corporate tax rate is 34%.
a. What is the value of XYZ before the restructuring?
b. What will be XYZ’s value after the restructuring?
c. What is the cost of equity after the restructuring?

Answer Key:

Vu = EBIT*(1-Tc) / Ru = 4000*0.66/0.15 = $17,600

Vl = Vu + D*Tc = $17,600 + $10,000*0.34 = $21,000
D/Vl = 10/21 and E/Vl = 11/21.
Re = Ru + (Ru – Rd)*D/E*(1-Tc) = 0.15 + (0.15-0.10)*10/11*0.66 = 0.18, or 18%

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