CC-Corp Finance

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Crash Course for Corporate Finance CFA Level-I Exam
Corporate Finance
Neev Knowledge Management Pristine
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Corporate Finance
Weighted Average Cost of Capital
Cost of Preference Stock
Cost of Equity Capital
Capital Budgeting
Working Capital Mgmt
Extended DuPont Expression
Pro Forma Financial Statements
Corporate Governance
Measure of Leverage
WACC=(wd)*kd*(1-t) + wpskps+ weke Cost of Equity using CAPM: ke=Rf+ *(Rmkt- Rf) Dividend and Share Repurchases
Q. Tax rate 35%, before tax cost of debt:6.5%, Capital Structure is 50:50 Cost of equity: 10.55% Ans.WACC=(0.5)*6.5%*( 1-0.35) + 0.5*10.55 WACC = 7.4%
10 yrs AAA rated bond Beta of market 1 yr market returns Credit rating of XYZ Beta of a stock XYZ Expected dividend
8.5% 1.0 12% BB 1.2 $5
Expected market return Debt/equity ratio Credit spread (BB bond) 10 yrs Govt. Bond Tax rate Dividends growth
20% 0.8 2.17% 7.33% 40% 10%
Q. Calculate the weighted average cost of capital using above information? a) 15% b) 17.5% c) 20% Ans. 15% Q. Which of the following will be a fair market price of stock according to Gordons formula? a) $ 25 b) $ 40 c) $ 30 Ans. $40
Q. Which of the following is most likely to be true, if there are no outstanding convertible securities? EPS <= Diluted EPS EPS => Diluted EPS EPS=Diluted EPS Ans. EPS=Diluted EPS
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Corporate Finance
Capital Budgeting
Measure of Leverage
kP=DPS/P Dividend and Share Repurchases
Q. Preference dividend = $2, Price of preference share = $20 Ans. Kp= 2/20 = 10%
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Corporate Finance
Capital Budgeting
Measure of Leverage
Ke= (D1/P0) + g or Ke= Rf + *(Rmkt - Rf + CRP)
Dividend and Share Repurchases
Country risk premium (CRP) = sovereign yield spread * ( of developing country equity index / of developed country sovereign bond)
levered= unlevered*(1+debt/equity)
This files has expired at 30-Jun-13 Q. Stock is quoting at $ 20, expected

dividend is $ 2, Growth rate = 5% Ans. cost of equity= 2/20+5%=15%
Q. If the difference between the yields of Govt. of India bonds denominated in Rupee and the treasury bonds of USA having same maturity, increases. What will be the effect on the cost of equity of a firm in India? Ans. Increases
Q. A company has been paying a dividend of $ 15 for each stock held. What shall be the stock price of the company if this dividend is expected to be received till infinity and expected rate of return by the investor is 10%? a) $ 15 b) $ 150 c) $ 100 Ans. P0 = 15 / 10% = $150
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Corporate Finance
Capital Budgeting
Measure of Leverage
NPV & IRR
Payback period
Profitability index
NPV =CF0+ [CF1/ (1+k)]+[CF2/(1+k)2]+ .+[CFn/ /(1+k)n] IRR: discount rate that makes NPV equal to 0.
PI = 1 + NPV/CF0
Payback period is no. of years it takes to recover initial project cost Discount payback uses present values of cash flows Treatment of Floatation Costs: Increase in Initial Cost of Project (Preferred) Incorporate Floatation Costs in discount rate (not preferred) If PI > 0, accept project If PI < 0, reject project Avg accounting rate of return (AAR) AAR= avg NI / avg BV
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Corporate Finance
Capital Budgeting
Measure of Leverage
Payables Turnover = Purchases / Average Trade Payables
Inventory Turnover = COGS / Average Inventory
Receivables Turnover = Credit Sales / Average Receivables
Cash Management Dividend and Share Repurchases
Q. Which of the following ratios cannot be directly observed in the common size statements? Inventory turnover Profit Margin Debt /Asset Ratio Ans. Inventory turnover ratio
This files has expired at 30-Jun-13 (face value

price) / face value Q. Which of the following is least likely to be bond with modifying maturity? Callable bonds Putable bonds Treasury bonds Ans. Treasury bonds
Bond Equivalent Yield = [(face value price)/ price] * (365/days to maturity)
Money Market Yield = [(face value price)/ price] * (360/day to maturity)
% Discount =
Q. A bond matures in one year and pays interest at maturity. If the face value of the bond and coupon rate is $500,000 & 9% respectively, and the required rate of return is 8%, what should be the present value? >$500,000 <$500,000 $500,000 Ans. >$500,000
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Corporate Finance
Capital Budgeting
Measure of Leverage
ROE= [O/P Income/Revenue] * [PBT/ (O/p Income)] * [PAT/PBT] * [Revenue / avg. total assets] * [avg. total assets/ avg. equity]

2010 Operating Margin Effects of nonoperating items Tax Effect Total asset turnover ratio Financial leverage ROE 78% 0.80 0.65 0.20 2.50 20% 2011 78% 0.77 0.65 0.19 2.86 21% 2012 78% 0.72 0.65 0.18 3.37 22%
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Corporate Finance
Capital Budgeting
Measure of Leverage
Dividend and Share Repurchases 1. Estimate the relations b/w changes in sales and changes in income statement & balance sheet items 2. Estimate future tax rate, interest rates on debt, lease payments etc. 3. Forecast sales 4. Estimate fixed operating and financial costs 5. Integrate these estimates into pro forma financial statements
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Corporate Finance
Capital Budgeting
Measure of Leverage
Favor Shareholder Interests
Independent board. Strong code of ethics Confidential voting
This files has expired at Interests 30-Jun-13

Managementaligned board Voting restrictions Takeover defenses
Harm Shareholder
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Corporate Finance
Capital Budgeting
Measure of Leverage

Breakeven: When Profit = 0 and Revenue = Costs Breakeven Points
Leverage is present because of: Fixed Operating Costs Use of Debt in capital structure z
Degree of Operating Leverage
QBE
F C P V
F P V
Operating Break Even:
DOL
Q( P V ) Q( P V ) F
Q( P V ) F Q( P V ) F C
QOBE
Degree of Financial Leverage
DFL
Degree of Total Leverage = DOL *DFL
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Corporate Finance
Capital Budgeting
Measure of Leverage
Regular Cash Dividends
Stock Splits

Dividend Reinvestment Plan (DRP) No floatation costs EPS and other per market data decline by half P/E, Dividend Yield are same Wealth remains same
Reverse Stock Splits
Share Repurchases
Special Dividends Used especially by cyclical companies in periods of strong earnings

Liquidating Dividends Company goes out of business
Earning yield > Cost of debt then EPS increases Earning yield < Cost of Debt then EPS is reduced
For equal taxation and information content cash dividends = share repurchases
If market price > BVPS then book value per share reduces after repurchase If market price < BVPS then book value per share increases after repurchase
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Question 1
Sigma Corporation is planning to launch a new product in the market for which it has paid Xylus Consultants a fee of $4000 to do a market survey to gauge the demand for the product. The new product is expected to cause a 5% decline in the market share of its existing brands. Also the facilities for the manufacturing of the project could earn a lease rent of $1500 per month, if the project were not to be undertaken. Which of the following regarding the project cash flow is least likely true? A. The cash flows should not take into account the consultants fee files has 30-Jun-13 B. The loss in This lease rent is relevant to expired the decision at making C. The loss of sale of existing product is irrelevant to the decision making
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Answer 1
C. The cost of cannibalisation should be considered in the incremental cash flows
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Question 2
Company A's stock is selling for $120 and the expected return on equity is 10%. Dividend planned for next year is $6 and the company plans to pay out 30% of its earnings. What is the cost of retained earnings for Company A using the discounted cash flow approach? A. 12.5% B. 15% C. 10%
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Answer 2
A. Kre = D1/P0 + g where g = (1-payout ratio) x ROE, P0 = Current price and D1 = Dividend expected. Hence, Kre = 6/120 + (1-0.3) x 0.1 = 0.125 i.e. 12.5%
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Question 3
A company is considering a project with future cash flows: Year Cash flow 0 -1500 1 450 2 400 3 513 4 580 This has expired at 30-Jun-13 The firm plans to investfiles in another project after its maximum payback period of 3 years. The WACC of the firm is 10%. Which of the following is least likely the companys decision regarding the two projects?
A. The first project is least likely to be profitable within the maximum payback period B. The first project should not have been accepted by the company in the first place C. The firms major concern is profitability and not liquidity as evident from the capital budgeting methods followed by it
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Answer 3
C. The maximum payback period method followed reflects that the firm is more concerned about the liquidity from the project as the payback period method is not appropriate to calculate the profitability of the project.
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Question 4
Rio Inc has invested $650 million in a real estate project. The present value of the after tax future cash flows from the project is $900 million, as estimated by the company. If Rio at present has 100 million shares outstanding trading at $50 per share, what should an analyst analysing Rio recommend to his clients about this company after receiving and analysing this information? A. Buy as the stock price is expected to rise to $52.5 B. Cannot be said with certainty This files has expired at 30-Jun-13 C. Buy as the stock price is expected to rise to $59
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Answer 4
B. The analyst may expect a lower level of profitability than that estimated by the company
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Question 5
A firm has a target equity share capital of $400 million and debt of $100 million. It raises another $120 million from the market through a rights issue. If the cost of equity is 13% and the after tax cost of debt is 8%, what is most likely the WACC of the firm after the additional fund raised? A. 12% B. 12.19% C. 11.27%
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Answer 5
A. The WACC is calculated based on the target capital structure of the firm which is 80:20. Hence, WACC is 0.8*0.13+0.2*0.08= 0.12
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Question 6
Plasma Inc is considering the purchase of an automatic capping machine to reduce labor costs. The machine is projected to save Plasma $5,000 per year. The machine costs $40,000 and is expected to last for 15 years. Plasma has estimated that their cost of capital for such an investment is 10%. For an extra $750 per year, Plasma can get a Good As New service contract. The contract keeps the machine in new condition forever. Net of the cost of the service contract, the machine would produce cash flows of $4250 per year in perpetuity. Which of the following decisions is the most appropriate?

A. Plasma should not avail of the service contract B. Plasmas profitability would increase if it accepts the service contract C. Plasma should not accept the entire project in the first place
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Answer 6
B. The NPV for purchase of machine only is negative (-$1970), however with the service contract the NPV is positive $2500 and the IRR is more than the WACC of the firm (10.81%).
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Question 7
What is a firm's weighted-average cost of capital if the stock has a beta of 1.45, Treasury bills yield 5%, and the market portfolio offers an expected return of 14%? In addition to equity, the firm finances 30% of its assets with debt that has a yield to maturity of 9%. The firm is in the 35% marginal tax bracket. A. 14.39% B. 12.66% C. 15.21%
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Answer 7
A. Cost of equity = 5+1.45(14-5) = 18.05% After tax Cost of debt = 9(1-0.35)=5.85% WACC = 0.3*0.0585+0.7*0.18= 14.39%
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Question 8
The opportunity cost of capital is 8%. Your firm is evaluating two mutually exclusive projects with scale differences. Each project requires an initial investment at time zero and produces one cash inflow at the end of the tenth year. Project A (the smaller project, requiring an initial investment of $10,000) has an internal rate of return of 9%. Project B (the larger project, requiring an initial investment of $12,000) has an internal rate of return of 10%. Which of the two projects has the higher NPV? A. Project A has the higher NPV. This files has expired at 30-Jun-13 B. Project B has the higher NPV C. Both projects have the same NPV.
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Answer 8
B. Since the IRR of project B is higher than project A , the NPV of project B will also be higher.
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Question 9
Chempro has planned to purchase a machine to add to the current production capacities to meet the growing demand of its products in the market. The following are the additional information provided in addition to the table below: All sales are on cash basis Interest on capital is 10% Corporate income tax is 40% Machine life is 2 years
Sr No 1 2 3 4 Description Initial Investment Estimated Sales Cost of goods sold Administration, selling and Distribution expenses Amount ($) 150,000 This files has expired at 30-Jun-13 250,000 75,000 20,000
What is the net cash flow from the project? A. $123000 B. $24000 C. $88000
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Answer 9
A. Initial investment 150000 Estimated sales (Annual) 250000 Cost of goods sold 75000 Admin, Selling and Distribution expenses 20000 Depreciation (2 years life) 75000 This files has expired at 30-Jun-13 Interest on capital (10% of investment) 15000 PBT 65000 Less : Tax at 40% PBT 16000 Profit After Tax 39000 Add: Depreciation 75000 Net Cash Flow 114000
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Question 10
In a mutually exclusive project, the IRR of project A is 20% while NPV at 10% cost of capital is $4000. The IRR of project B is 18% while NPV at 10% cost of capital is $6000, the preferred capital budgeting method to be chosen is A. IRR B. NPV C. Discounted Payback
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Answer 10
B. NPV is the preferred method in capital budgeting . Only if NPV is the same then IRR is compared.
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Question 11
In Drag on liquidity pressures from credit management deteriorates because: A. Payments are made before due dates to vendors, employees and contractors. B. Banks which trades with the company reduces the line of credit. C. Uncollected receivables are longer and many may not be collected along with increasing bad debt expenses.
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Answer 11
C. Drag on liquidity is delay or reduction in cash inflow. Hence only option Uncollected receivables are longer and many may not be collected along with increasing bad debt expenses causes drag on liquidity.
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Question 12
Silverton Inc is considering a project in the garment manufacturing industry. It has a D/E ratio of 1.2 and its debt currently has a after tax return of 6%.Ashley Inc is a publicly traded company which is only in the garment manufacturing business with a D/E ratio of 2 and equity beta of 1.1. If the risk free rate is 5% and return on market is 10%, find the appropriate WACC to be used to evaluate Silvertons project. Assume tax rate of 40% A. 8.6% B. 7.5% C. 10.3%
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Answer 12
B. Ashleys unlevered/asset beta = 1.1*[1/{1+(1-0.4)*2}] = 0.5. Silvertons project beta = 0.5*[1+(1-0.40)*1.2]= 0.86 Silvertons cost of equity using CAPM = 0.05+0.86(0.1-0.05) =9.3% WACC = (1.2/2.2)*0.06+(1/2.2)*0.093 = 0.075
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Question 13
Zeta Technologies is planning to expand into China. The following information is available: Chinese US dollar denominated 10 year Govt bond yield= 8.9% 10 Year US treasury bond yield = 4.8% Annualised standard deviation of Chinese stock Index= 23% Annualised std dev of Chinese US dollar denominated 10 year govt bond = 14% Find the country risk premium of China.

A. 8.93% B. 5.54% C. 6.73%
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Answer 13
C. Country risk premium= (8.9-4.8)*(23/14) =6.73%
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Question 14
What happens to a companys weighted average cost of capital if the firms corporate tax rate increases and if the risk free interest rate decreases, considering the two events separately? Tax rate increase / Decrease in risk free rate A) Decrease / Decrease B) Increase / Decrease C) Decrease / Increase
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Answer 14
A. Increase in the tax rate will reduce the cost of debt and decrease in the risk free rate will decrease the cost of equity
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Question 15
Under which of the following circumstances would a company be most likely to avail of a trade discount? A. Company with a high payable turnover B. Availability of low cost funds to finance the working capital requirements C. Company with a low payable turnover
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Answer 15
B. In such a situation the company would prefer to pay off the payables and use the low cost funds available to finance its working capital requirements.
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Question 16
Which of the following would most likely to be a sign of independence, prudence of the auditing committee?
A. 2/3 of the audit committee comprises of independent members and committee is chaired by managing director B. Same external auditor is advising company management in M&A activities C. Committee members are financial experts
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Answer 16
C. Auditing committee headed by management director is more likely to create a principal agent problem and would not be effective in protecting shareholders interest
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Question 17
The difference between primary and secondary sources of liquidity is A. Primary source is easily accessible from the market than secondary source of liquidity. B. Primary source is likely to affect the normal operations of the company whereas using the secondary source will not result in companys financial and operating position. C. The normal operations are not affected while using primary source but secondary source will result in changing the companys financial and operating position.
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Answer 17
C. Primary source of liquidity are the sources of cash it uses in its normal day to day operations. Secondary source of liquidity include liquidating short term or long lived assets etc.
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Question 18
American Outlook Inc. is issuing bonds to obtain the funding necessary to acquire a major competitor. Review of the balance sheets indicates that American Outlook has also issued preferred and common stock in the past. Which component cost(s) should American Outlook use in evaluating the financial cost of acquiring the new firm? A. The weighted average component cost of common stock, preferred stock and debt B. The price the firm paid for its assets divided by their market value C. The cost of the new debt issue alone
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Answer 18
A. How a company raises capital and how it invests it are considered independently. In the short run, a company may highlight the latest capital issued. But in the long run the firm would look at a targeted capital structure and hence the investment decision should be made assuming a weighted average cost of capital including each source of capital.
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Question 19
Which of the following is a case where there is a problem in using the IRR? A. Mutually exclusive projects B. Cost of capital not available C. Cut-off rate is high
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Answer 19
A. While NPV and IRR are useful metrics for analyzing mutually exclusive projects - that is, when the decision must be one project or another - these metrics do not always point you in the same direction. This is a result of the timing of cash flows for each project. In addition, conflicting results may simply occur because of the project sizes.
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Question 20
Accounting beta is calculated by running a regression using A. Company's turnover against the operating turnover for market benchmark B. Company's operating margin against the operating margin for market benchmark C. Company's return on assets against the return on assets for market benchmark
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Answer 20
C.
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Question 21
A company XYZ Ltd sells 10,000 units of water bottles at a price of $4 per unit. ABCs fixed costs are $10,000 and it pays an annual interest of $ 3,000.The variable cost of production is $ 2 per unit and the operating profit (EBIT) is $ 14,000. Which of the following statements is true? A. Degree of Operating leverage = 2.00 , Degree of Financial leverage = 1.27 B. Degree of Operating leverage = 1.27 , Degree of Financial leverage = 2.00 C. Degree of Operating leverage = 1.27 , Degree of Financial leverage = 1.50
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Answer 21
A. Degree of operating leverage = Q*(P-V)/ (Q*(P-V)-F) Where Q = number of units sold = 10,000 P = Cost price per unit =$4 V = Variable cost per unit = $2 F = Fixed cost = $10,000 Hence DOL = 10,000*($4-$2)/ (10,000*($4-$2) -$10,000) = 2.00 This files at 30-Jun-13 Degree of Financial leverage = has EBIT/ expired (EBIT Interest) = $14,000/ ($14,000-$3,000) = 1.27
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Question 22
25% increase in sales of Irrelevant Corporation causes 50% growth in EPS If operating earnings of the company is $ 12,000 and financial leverage is 1.5. Calculate operating earnings of the company if sales increase by 10% next year A. 15000 B. 14000 C. 13000
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Answer 22
B. Total leverage = EPS growth/sales growth Operating leverage (OL) = total leverage/financial leverage New operating income = old income *(1+ OL * sales growth)
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CC-Corp Finance

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www.edupristine.

This files has expired at 30-Jun-13

Crash Course for Corporate Finance CFA Level-I Exam

This files has expired at 30-Jun-13

Neev Knowledge Management Pristine

Cost of Preference Stock

Cost of Equity Capital

Working Capital Mgmt

Extended DuPont Expression

Pro Forma Financial Statements

This files has expired at 30-Jun-13

8.5% 1.0 12% BB 1.2 $5

20% 0.8 2.17% 7.33% 40% 10%

Neev Knowledge Management Pristine

Cost of Preference Stock

Cost of Equity Capital

Working Capital Mgmt

Extended DuPont Expression

Pro Forma Financial Statements

kP=DPS/P Dividend and Share Repurchases

This files has expired at 30-Jun-13

Neev Knowledge Management Pristine

Cost of Preference Stock

Cost of Equity Capital

Working Capital Mgmt

Extended DuPont Expression

Pro Forma Financial Statements

Ke= (D1/P0) + g or Ke= Rf + *(Rmkt - Rf + CRP)

Dividend and Share Repurchases

This files has expired at 30-Jun-13 Q. Stock is quoting at $ 20, expected

Neev Knowledge Management Pristine

Cost of Preference Stock

Cost of Equity Capital

Working Capital Mgmt

Extended DuPont Expression

Pro Forma Financial Statements

NPV & IRR

Dividend and Share Repurchases

This files has expired at 30-Jun-13

Neev Knowledge Management Pristine

Cost of Preference Stock

Cost of Equity Capital

Working Capital Mgmt

Extended DuPont Expression

Pro Forma Financial Statements

Payables Turnover = Purchases / Average Trade Payables

Inventory Turnover = COGS / Average Inventory

Receivables Turnover = Credit Sales / Average Receivables

Cash Management Dividend and Share Repurchases

This files has expired at 30-Jun-13 (face value

Bond Equivalent Yield = [(face value price)/ price] * (365/days to maturity)

Money Market Yield = [(face value price)/ price] * (360/day to maturity)

Neev Knowledge Management Pristine

Cost of Preference Stock

Cost of Equity Capital

Working Capital Mgmt

Extended DuPont Expression

Pro Forma Financial Statements

Dividend and Share Repurchases

This files has expired at 30-Jun-13

Neev Knowledge Management Pristine

Cost of Preference Stock

Cost of Equity Capital

Working Capital Mgmt