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solve the questions step by step please. all the questions from finance class.


Take-Home Final Exam

 

Course: Business 330 - Principle of Finance

 

Date due: as announced in class (05/03/16)

 

1) Answer all questions. Total points of the test: 280.

 

2) Provide clear statements and analyses. State your assumptions whenever you

 

need them. Do turn in on time. No late turn-in will be accepted. Do not

 

collaborate in all respects. If you violate this policy, you will fail this test.

 

3) Good Luck! God bless you all.

 

1. (10 points) Explain the ideas of Systematic, Un-systematic Risk and their relationship

 

with CAPM. What kind of portfolios will have their expected rates of returns (versus

 

their ?beta?s?) located on the Security Market Line?

 

2. (20 points) You?re given with a 5-year auto loan from your credit union. Suppose the

 

total loan you have is $32,000 and the current market interest rate is 4.6% for the shortterm loans with the same creditability as yours. Answer the following questions:

 

a) Given that the APR (namely the Annual Percentage Rate. That is, the stated

 

interest agreed on the loan) of the loan is 4.6% per year, what is the monthly

 

payment if you?re intended to have the loan for 5 years?

 

b) What is the effective annual rate if the loan is compounded monthly?

 

c) Suppose the credit union says that if you?d like to retire the loan earlier, say at the

 

end of the 3rd year, you need to pay (say) $18,000 for the rest of the loan, would

 

you take it given that you have no difficulty to generate the cash flow? Why or

 

why not?

 

d) Suppose the original agreement that you signed with credit union is to have a 3year loan and pay back the loan with $21,200 at the end of year 3, how much will

 

be your monthly payment now?

 

e) Given that the present value of the loan which is $25,000 now, what is the Internal

 

Rate of Return (IRR) for this loan? Is this rate different from the 4.6% market

 

interest rate? Why or why not?

 

3. (40 points) You are given with the following information of two projects planned by

 

your company. Each cash flow per year shown in Table 1 represents the cash flow at

 

the end of each year during the project. For instance, for project A, the cash flow as 735

 

in first year is expected at the end of the Year 1. The initial outlays for the projects are

 

paid out by installments with regular payments as 0.84 million at the beginning of each

 

year for project 1 and $0.91 million per beginning of each year for project 2,

 

respectively.

 

Project

 

A

 

B

 


 

Year 1

 

523

 

638

 


 

Table 1: (in thousands)

 

Year 2

 

Year 3

 

Year 4

 

2390

 

1029

 

2327

 

3189

 

1842

 


 

Answer the following questions.

 


 

Year 5

 

2601

 


 

a) Suppose the cost of capital is 14%, what is the Net Present Value for each

 

project? Which project would you prefer? Why?

 

b) What are the pros and cons in using the NPV decision rule for the capital

 

budgeting?

 

c) Let the corporate income tax rate be 22%, the cost of debts (that is, the interest

 

rate) be 6.5%, the cost of equity be 26% and there is no preferred stock issued by

 

the firm. Assuming the weighted average cost of capital is given as 14% in a),

 

what is the debt-to-equity ratio for your company?

 

d) Find the IRR (Internal Rate of Return) for project A and project B. What is your

 

decision based on the IRR criterion?

 

e) Suppose there is a 40% chance that the market may be bad and the cash flows for

 

both projects when market condition is bad will change to

 

Project

 

A

 

B

 


 

Year 1

 

350

 

376

 


 

Year 2

 

720

 

-1872

 


 

Year 3

 

-919

 

-1008

 


 

Year 4

 

-1092

 


 

Year 5

 

-1321

 


 

That is to say, the original cash flows in Table 1 only have 60% chance to happen. What

 

is your decision for each project? What is the value contributed by the ?Real Option?(that

 

is, the possibility to discontinue the project) for each project if you can discontinue the

 

projects when you find out that they may not be successful when possible negative cash

 

flows are expected?

 

4. (40 points) You are given with the following information of two proposals of financing

 

programs for your home loan. Suppose the new house costs you $672,400 (sales taxes

 

and others are included). One program is asking you to deposit a 20% down payment on

 

the $672,400 and it provides you with 2.4% interest rate for 15-year monthly payments of

 

the remaining balance, the other program is a 100% financing program which gives a

 

1.2% for the first 5 year plus the PMI (property mortgage insurance) as $150 per month

 

with a balloon payment as $650,000, (that is, a lump-sum payment at the end of 5 th year).

 

The mortgage rate increases to 4.8% afterward for a 30-year mortgage if the balloon

 

payment is not paid and refinancing is applied (That is, the extended program for

 

refinancing is for 30 years and it?s not for the 25 years leftover only). Let there be no

 

prepayment penalty. That is, you may pay off the loan should you have some extra cash

 

later on. The brokerage fees and commissions are already taken into account in all the

 

numbers given. Answer the following questions:

 

a) What is the monthly payment for each program in the first 5 years? Which one more

 

favorable to you if your monthly income is $6,000 before tax? (Notice that most

 

lenders will require the borrower to have the ratio between mortgage payment and

 

monthly gross income no greater than 33%).

 

b) Suppose 4 years later, the market price of your house is $768,000. The tax rate on

 

gains/losses on house sales is 6%. Will you consider selling this house and buy a

 

bigger one if your income has gained to $8500 per month? What is the annualized

 


 

rate of return net of your financing cost in your housing investment for each

 

financing program?

 

c) Suppose there is a 12% income tax on your gain in selling your house, how much is

 

the after-tax return now for each financing program?

 

5. (40 points) You have the following information for the company ?Spy?. The ?beta?

 

coefficient for ?Spy? is 1.05 based on the past information. The 5-year average of 30-day

 

T-bill rate is 2%, the average market return of (say, S&P 500 index) in the same period is

 

14.5%. Answer the following questions:

 

a) What is the required rate of return for ?Spy?? Why do we call it ?required? rate of

 

return?

 

b) Suppose the current dividend for ?Spy? is $3.12 per share with possible expected

 

growth rate as 7% per year from now on, what is your assessment for the value of

 

Spy?s stock?

 

c) Suppose without using the information of ?beta?, the current market price for the

 

?Spy?s stock is $26.50 per share. Let the capital market be efficient as ideally

 

assumed. That is, the current stock price is equal to the stock?s present value.

 

What is the required rate of return for this stock now if the information in (b) still

 

applies? What is the ?beta? associated with this stock now?

 

d) ?Spy? has the following capital structure: the firm issued 6 million shares of

 

common stock with the stock price given in c) and dividend in b), the firm also

 

issued 2 million shares of preferred stock with $1.09 preferred dividend per share,

 

and currently, ?Spy? has $90 million in debts with interest rate as 6%. Suppose

 

the current preferred stock price is $6.72 per share. The corporate tax rate is 30%

 

and the common stock price is as given in c), what is the (after-tax) weighted

 

average cost of capital (after tax) for ?Spy??

 

e) What is meaning of ?Weighted Average Cost of Capital (after tax)?? Why do we

 

usually apply it as the discount rate for expected future cash flows in capital

 

budgeting decisions?

 

6. (30 points) Let the information on your portfolio be given as follows. You have three

 

funds in the basket. The "beta's" among them that are estimated by using S&P 500 index

 

are given as follows; 1 = 0.47, 2 = 1.83 3 = 0.92. Answer the following questions;

 

a) Why do we need these "beta's" to construct the portfolio?

 

b) If the risk-free rate is given as 2%, what are the required returns for fund 1 and

 

fund 2 if the market rate of return is expected to have 12%?

 

c) Is it possible to construct a risk-free (or zero-beta) portfolio by combining asset 1

 

and asset 2? If yes, what is the required return for this portfolio? If the transaction

 

cost for this portfolio requires 2.5% of commission, will you do it?

 

d) If you'd like to form a portfolio with fund 1 and fund 2 that replicates fund 3?s

 

beta, what are the weights of this portfolio? What are the assumptions needed for

 

the construction of such portfolio?

 


 

7. (40 points) Company Wii gives you the following information for its operation. The

 

expected income available for dividends is $42 million next year before the firm has

 

any debts. Suppose there is a 25% corporate income tax imposed on the company.

 

Company Wii has no debt originally. There are 6 million shares of common stocks

 

outstanding. Let the market price for the stock be $42.5 per share before debt.

 

Suppose that there is no expansion plan for the company to either spend on working

 

capital vs. long-term investment or to apply the accumulated retained earning.

 

Answer the following questions:

 

a) What is the possible dividend per share for the common stock before company

 

Wii has debt? What is the cost of equity for Company Wii?s stock before debt?

 

Suppose that Company Wii now has issued some bonds with 6% coupon rate recently.

 

Let Company Wii?s total debts (with the above coupon bond) be $80 million and let

 

this coupon rate represent the cost of debt, how much will be the value of

 

stockholders? equities under Modigliani and Miller?s proposition 2?

 

b) What is the cost of equity for Company Wii, if there?s no preferred stock issued

 

for this company?

 

c) What is the weighted average cost of capital after Company Wii has debts?

 

d) Suppose the risk-free rate is 2%, S&P 500 index return is 12%, what is the

 

?beta? of Company Wii?s common stock after issuing debts?

 

e) What are the limitations of M&M proposition 2?

 

8. (20 points) You are given with the following information of a firm "Hunger Game" in

 

food industry. Assume that the firm did not issue preferred stocks while the firm may

 

have some foreign subsidiaries overseas. The firm is making hi-tech instruments for

 

medication. This industry tends to have gross profit margin such as 18% and other

 

set-up costs are also high due to the production and technology. The R&D (Research

 

and Development) costs are entirely reported as operating expenses according to the

 

GAAP.

 

Balance Sheet (in millions)

 

Assets

 

Cash

 

Marketable securities

 

Accounts Receivable

 

Inventory

 

Plant, Building, and Equipment (net)

 

Investments in affiliates

 

Total Assets

 

Liabilities

 

Short-term debts

 

Advances from customers

 

Accounts payable

 


 

2011

 


 

2012

 


 

2013

 


 

130

 

51

 

220

 

1062

 

1873

 

0

 


 

210

 

200

 

350

 

1078

 

2203

 

430

 


 

70

 

1000

 

200

 

450

 

1790

 

329

 


 

3336

 


 

4471

 


 

3839

 


 

107

 

121

 

585

 


 

130

 

326

 

1092

 


 

30

 

534

 

357

 


 

Interest payable

 

Tax payable

 

Other Accrued Expenses

 

Bonds payable

 


 

75

 

147

 

20

 

1028

 


 

298

 

120

 

15

 

1076

 


 

62

 

128

 

35

 

450

 


 

1001

 

74

 


 

1201

 

154

 


 

1975

 

144

 


 

178

 

3336

 


 

59

 

4471

 


 

124

 

3839

 


 

Net Sales

 

Cost of Goods Sold

 

Selling and General Expenses

 

Depreciation Expense

 

Interest Expense

 


 

2011

 

6529

 

2215

 

1771

 

213

 

397

 


 

2012

 

5418

 

3109

 

812

 

169

 

109

 


 

2013

 

6083

 

3310

 

1059

 

484

 

221

 


 

Income Tax Expense

 

Net Income

 


 

275

 

1658

 


 

237

 

982

 


 

254

 

755

 


 

Stockholders' Equity

 

Common stock

 

Additional paid-in capital

 

Retained earning

 

Total liabilities and equities

 

Income Statement(in millions)

 


 

a) Perform the Ratio Analysis for the firm. (Present all ratios you know.) Will the

 

accounting policy on revenue recognition influence the ratios? Why or why not?

 

b) Show the Common-Size Statements for Company Hunger Game.

 

c) Given your result in a), what is your opinion on the firm's performance so far?

 

What is the firm's strategy in raising capital? What are the firm's possible

 

business and financial strategies in your opinions?

 

d) Given the above information, what will be possible dividend per share for 2013

 

of Company Hunger Game? Suppose the firm has 6 million shares of stock

 

issued in the market, what is the possible required rate of return for their stock if

 

you based on the shareholders? equity of 2013?

 

9. (20 points) Consider the following claims. Answer them with ?True? or ?False?

 

and your explanation. No credit will be given if no explanation is shown.

 

a) All firms can issue debts if their asset values are sufficient enough. In particular,

 

the values of the firms will always increase as they raise more debts since

 

interests on corporate debts are tax-deductible.

 

b) If the capital market is so efficient that all essential information for the firms?

 

values is disclosed in the public, then there is no chance for any investor to make

 

a profit.

 


 

c) One of the drawback of Net Present Value principle is that one will easily tend to

 

accept the project(s) that have less years of cash flows - if other things being

 

equal.

 

d) The expected rate of return for a stock when determined by the Capital Asset

 

Pricing Model (CAPM) is the ?goal (or target)? of the rate of return for the firm?s

 

equity. Hence, if the stock returns actually reach this rate, it is good enough

 

already.

 

e) Capital budgeting is to determine the best capital structure for the firm in raising

 

capital from the capital market.

 

f) To calculate the weighted average cost of capital is to assume that expected rates

 

of return from different sources are evaluated according to relative contributed

 

proportions on entire capitalization without references to where and who

 

contributed the fund.

 

g) The yield to maturity of the corporate bond is always the expected rate for return

 

for bondholders, regardless of their intended holding horizons of the bonds.

 

10. (20 points) Suppose that you?re given the following information of rates of return for

 

the stock market as assessed by your financial analyst in mutual fund. Answer the

 

following questions:

 

a) What are the means, standard deviations for each fund? Why does the ?mean? of

 

the rate of return represent the expectation on the risky asset?

 

b) What are the co-variances for these funds? Are these funds mutually

 

?diversifiable?? Why or why not?

 

c) Explain the assumption(s) and reason(s) why the expected rate of return of

 

investor can be represented by the expected value of the rate of return.

 

d) Suppose that Fund A represents the Market Portfolio. Let the risk-free rate be 3%,

 

what are the required rates of return for Fund B, and Fund C?

 

States of

 

world

 

Boom

 

Recovery

 

Recession

 


 

the Probability

 

1/2

 

1/4

 

1/4

 


 

Fund A

 

12%

 

18%

 

4%

 


 

Fund B

 


 

Fund C

 


 

36%

 

8%

 

-12%

 


 

18%

 

16%

 

-8%

 


 

e) Explain the M&M proposition 1 in words and intuition. Do not copy the equations

 

given in the class.

 


 

 

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