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Final Exam sample questions

Corporate Finance (Griffith University)

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7211AFE Corporate Finance – Practice Questions for Final Exam

Question 1
The risk-free rate of return is 4% and the market risk premium is 8%. What is the expected
rate of return on a stock with a beta of 1.28?
Answer: 14.24%
CAPM R = Rf + b(Rm-Rf) = 4% + 1.28*8% = 14.24%

Question 2
Assume that Diamond Ltd’s last dividend was $2 per share and the dividend is expected to
grow at 7.5% indefinitely. The shares currently sell for $30. What is Diamond Ltd’s cost of
equity capital?
Answer: 14.7%

Question 3
Nuovo, Inc. stock has a beta of .86 and an expected return of 10.5 percent. The risk-free rate
of return is 3.2 percent and the market rate of return is 11.2 percent. Is this stock underpriced
or overpriced? Why? CAPM= 10,08, RRR=8,4%
Answer: Nuovo stock is underpriced.

Question 4
EBIT for Sharks Ltd is $163.934 and the cost of capital (Ru) is 20%. Taxes are 39%. What is
the value of the firm?
Answer: $500

Question 5
The expected return on HiLo stock is 13.69 % while the expected return on the market is
11.5%. The beta of HiLo is 1.3. What is the risk-free rate of return?
Answer: 4.2%

Question 6
Priscilla owns 500 shares of Delta stock. The company recently issued a statement that it will
pay a $1.00 per share dividend this year and a $.50 per share dividend next year. Priscilla does
not want any dividend this year but does want as much dividend income as possible next year.
Her required return on this stock is 12 percent. Ignoring taxes, what will Priscilla’s homemade
dividend per share be next year?
Answer: $1.62

Question 7
Calculate the expected return from the following information:
Event Prob. Of event happening Return
A .25 .5
B .50 .2
C .20 .1
D .05 -.2
Answer: 0.235

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Question 8
What is the market return if the expected return on asset A is 15% and the 10-year
government bond rate is 6%. Beta for asset A is .9.
Answer: 16%

Question 9
What is the portfolio variance if 30 percent is invested in stock S and 70 percent is invested in
stock T?

State of Probability of Returns if State Occurs

Economy State of Economy Stock S Stock T
Boom 40% 12% 20%
Normal 60% 6% 4%
Answer: 0.004056
We now have the payoffs in each state:
Use equation (28)
E(RP) = pr(boom) ×payoff(boom) + pr(normal) ×payoff(normal)
= 0.4×0.176+0.6×0.046 = 0.098
Now use equation (29)
Var(RP) = 0.4 × (0.176-0.098)2+ 0.6 × (0.046-0.098)2 = 0.004056

Question 10
Starfish limited has a WACC (unadjusted) of 12%. It can borrow at 8%. Assuming that the
company has a target capital structure of 80% equity and 20% debt, what is its cost of equity?
Answer: 13%

Question 11
Merlo, Inc. maintains a debt-equity ratio of .40 and follows a residual dividend policy. The
company has after-tax earnings of $1,600 for the year and needs $1,400 for new investments.
What is the total amount Merlo will pay out in dividends this year?
Answer: $600

Question 12
You recently purchased a stock that is expected to earn 12 % in a booming economy, 8 % in a
normal economy and lose 5 % in a recessionary economy. There is a 15 % probability of a
boom, a 75 % chance of a normal economy, and a 10 % chance of a recession. What is your
expected rate of return on this stock?
Answer: 7.30 %

Question 13
Shares are currently selling for $4.4625. At the beginning of the year you bought them for
$4.25 and during the year a dividend of 21.25 cents per share was paid. What is the return?
Answer: 10%

Question 14
Which one of the following stocks is correctly priced if the risk-free rate of return is 2.5
percent and the market risk premium is 8 percent?

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Stock Beta Expected Return

A .68 8.2%
B 1.42 13.9%
C 1.23 11.8%
D 1.31 12.6%
E .94 9.7%
Answer: B
The market risk premium is E(Rm)-Rf = 0.08, Rf = 0.025
E(RA) = Rf + b (E(Rm)-Rf) = 0.025 + 0.68×0.08 = 0.0794
E(RB) = 0.1386
E(RC) = 0.1234
E(RD) = 0.1298
E(RE) = 0.1002
Stock B is correctly priced (assuming the CAPM holds).

Question 15
Using the following information, calculate the portfolio beta and expected return:
Event Wealth invested Expected return Beta
A $1,000 8% 0.80
B $2,000 12% 0.95
C $3,000 15% 1.10
D $4,000 18% 1.40
Answer: 1.16, 14.9%

Question 16
Shoes’R’Us is an unlevered firm. Cost of capital for the firm is 10%. The firm’s cash flows
are $700 every year forever. What is the value of the firm?
Answer: $7000

Question 17
Zelo, Inc. stock has a beta of 1.23. The risk-free rate of return is 4.5 % and the market rate of
return is 10 %. What is the amount of the risk premium on Zelo stock?
Answer: 6.77 %

Question 18
If the economy booms, RTF Inc. stock is expected to return 10 %. If the economy goes into a
recessionary period, then RTF is expected to only return 4 %. The probability of a boom is 60
% while the probability of a recession is 40 %. What is the variance and standard deviation of
the returns on RTF Inc. stock?
Answer: 0.000864, 2.9%

Question 19
The Lingo Co. has a debt-equity ratio of .60. The firm is analyzing a new project which
requires an initial cash outlay of $450,000 for new equipment. The flotation cost for new
equity is 10 percent and for debt 5 percent. What is the true cost of the project?
Answer: $489,796

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Question 20
You own 300 shares of Abco, Inc. stock. The company has stated that it plans on issuing a
dividend of $.60 a share at the end of this year and then issuing a final liquidating dividend of
$2.20 a share at the end of next year. Your required rate of return is 9 percent. Ignoring taxes,
what is the value of one share of this stock today?
Answer: $2.40

Question 21
Astra limited company sells a slice of pizza for $1.20. The variable cost is 80 cents per slice
and the marketing operation has fixed costs of $360 000 per year. Depreciation is $60 000 per
year. What is the accounting break-even?
Answer: 1 050 000 slices of pizza

Question 22
Rosie’s Grill has a beta of 1.2, a stock price of $26 and an expected annual dividend of $1.30.
The dividend growth rate is 4 %. The market has a 10 % rate of return and a risk premium of
6 %. What is the average expected cost of equity for Rosie’s Grill?
Answer: 10.10 %

Question 23
What are the arithmetic and geometric average returns for a stock with annual returns of
21 %, 8 %, -32 %, 41 %, and 5 %?
Answer: AM 8.6 %; GM 5.6 %

Question 24
Sparkle Inc has a debt-equity ratio of 1. Its weighted average cost of capital is 11%, and its
cost of debt is 9%. The corporate tax is 35%.
a) What is Sparkle’s cost of equity capital?
b) What is Sparkle’s unlevered cost of equity?
c) Sparkle is increasing its debt proportion in the firm (at the same cost) so that the debt-
equity ratio is 1.5? What is the cost of capital then?
Answers: a) 16.15%; b) 13.33%; c) 10.53%

Question 25
The Lakeside Inn is considering expanding their operations. Fixed costs are estimated at
$92,000 a year. The variable cost per unit is estimated at $22.50. The estimated sales price is
$37.50 per unit. What is the cash break-even point of this project? (Round to whole units)
Answer: 6,133

Question 26
Tom’s Ventures has a zero coupon bond issue outstanding that matures in thirteen years. The
bonds are selling at 48 % of par value. The company’s tax rate is 34 %. What is the
company’s after-tax cost of debt?
Answer: 3.83 %

Question 27

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Suppose that your firm has a cost of equity of 18% and a cost of debt of 8%. If the target D/E
is 0.60 and the tax rate is 35%, what is the firm’s WACC?
Answer: 13.2%

Question 28
A stock had returns of 8 percent, -2 percent, 4 percent, and 16 percent over the past four
years. What is the standard deviation of this stock for the past four years?
Answer: 7.5%

Question 29
Your firm has earnings before interest and taxes of $160,000. Both the book and the market
value of debt is $300,000. Your unlevered cost of equity is 12% while your cost of debt is
8%. The tax rate is 35%. What is your weighted average cost of capital?
Answer: 10.7%

Question 30
A company has preferred stock outstanding which pays a dividend of $6 per share a year. The
current stock price is $75 per share. What is the cost of preferred stock?
Answer: 8%

Question 31
You are considering a new project. The project has depreciation of $720, fixed costs of
$6,000, and selling price per unit of $9.80. The variable cost per unit is $4.20. What is the
accounting break-even level of production?
Answer: 1,200 units

Question 32
Douglass Enterprises has a capital structure which is based on 40 percent debt, 10 percent
preferred stock, and 50 percent common stock. The after-tax cost of debt is 6 percent, the cost
of preferred is 7 percent, and the cost of common stock is 9 percent. The company is
considering a project that is equally as risky as the overall firm. This project has initial costs
of $125,000 and cash inflows of $76,000 a year for two years. What is the projected net
present value? Should this project be accepted or rejected?
Answer: $11,275.07, yes

Question 33
Katie’s Boutique has zero-coupon bonds outstanding that mature in four years. The bonds
have a face value of $1,000 and a current market price of $820. What is the company’s pre-
tax cost of debt?
Answer: 5.09 %

Question 34
Spartan Co. has earnings of 25 million per year every year. Currently the firm has no debt and
the cost of capital is 13%. If tax is 35% what is the value of the firm?
Answer: $125m
Earnings are $25m/year; no debt WACC = 0.13, t=0.35
VU = EBIT(1-t) / RU = (25m) (1-0.35) / 0.13 = $125m

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Question 35
Spartan Co decides to undergo a capital restructuring by issuing bonds that have a market
value of 65 million at a cost of 9.5%. What is the weighted average cost of capital?
Answer: 11%
You issue bonds with a market value of $65m, value of leverage firm:
VL= VU+ TC×D = 125m + 0.35×65m = 147.75m
=> E = 147.75m – 65m = 82.75m; wD=65/147.75 = 0.44; wE= 0.56
Hence D/E = 65.0/82.75 = 0.785
Recall (46): Cost of equity
RE = RA + (RA – RD ) ×(D/E) ×(1-t) = 0.13 + (0.13 – 0.095) (65/82.75) (0.65) = 0.1479
Recall (37):
WACC = wERE + wDRD (1-t)
= 0.56 (0.14787) + 0.44 (0.095)(1-0.35) = 0.11

Question 36
After successful operating for a number of years, Spartan Co decides to increase even further
the leverage so that the debt-to-equity ratio becomes 1.2. What is the cost of capital?
Answer: 10.52%
RE = 0.13 + (0.13 – 0.095)(1.2)(0.65) = 0.1573
If D/E = 1.2, D=1.2 & E=1.0, => wD= 1.2/2.2, wE=1/2.2
WACC = wERE + wDR (1-t)
= (1.0/2.2) (0.1573) + (1.2/2.2) (0.095) (0.65) = 0.10518

Question 37
Calculate the expected return of the portfolio:
Asset Wealth invested E(Ri)
A 200 15%
B 100 20%
C 500 10%
Answer: 12.5%

Question 38
ABC limited have 50 000 shares outstanding that sell in the market for $17.50 each. Share’s
beta coefficient is 1.2. The market risk premium is 8% and the risk-free rate is 5%. What is
ABC limited’s cost of equity capital and the market value of equity?
Answer: 14.6%, $875 000

Question 39
Uptown Interior design has the same market value as the book value of its balance sheet
accounts. The firm has declared a dividend of $0.35 per share that will be paid in two days
time. The company has 8,000 shares of stock outstanding trading in the market. The balance
sheet is presented in the following table:

Balance Sheet
Cash 25,000 Equity 190,000
Fixed Assets 165,000
Total 190,000 Total 190,000

a) Ignoring taxes, what is the stock selling for today?

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b) What will it sell in two days time after the ex dividend date?
c) What are the accounts affected after the dividends are paid and what will be their new
balance?
Answers: a) $23.75; b) $23.40 c) Cash $22 200 and Equity $187 200

Question 40
Uptown Interiors has decided to consider an alternative to cash dividend. Instead of paying a
dividend, the firm will repurchase $5 200 worth of stock.
a) What effect will this transaction have on the equity of the firm?
b) How many shares were repurchased? (round your answer)
c) How many shares will be outstanding?
d) What is the new equity value?
e) What will the price per share be after the repurchase?
Answer: a) reduce; b) 219; c) 7 781; d) $184 800; e) same $23.75
a) If you repurchase the stock, this is similar to a cash dividend;
your cash account falls by $5200 and so does your equity account.
b) Since the price is 23.75 then you retire 219 shares
Shr repurchased =cash/P= $5200/23.75 = 219
c) The number of shares outstanding falls from 8000 to 7781 (=8000-219).
d) New equity value, E’ = E – cash = 190,000 – 5200 = 184,800
e) Since stock repurchases do not impact the value of the firm,
price/share remains unchanged at $23.75

Question 41
Shirley’s and Son have a debt-equity ratio of .60 and a tax rate of 35 %. The firm does not
issue preferred stock. The cost of equity is 10 % and the cost of debt is 8 %. What is Shirley’s
weighted average cost of capital?
Answer: 8.2 %

Question 42
You are an investor in BHP and own 100 shares. BHP shares sell for $41. The company is
about to pay a $1 dividend but you prefer a $3 dividend. What will you do to receive the
desired income of $300?
Answer: sell 5 shares ex dividend

Question 43
Today, you sold 200 shares of SLG Inc. stock. Your total return on these shares is 12.5
percent. You purchased the shares one year ago at a price of $28.50 a share. You have
received a total of $280 in dividends over the course of the year. What is your capital gains
yield on this investment?
Answer: 7.59 %
-1 0
28.5 P0+1.4 DPS = Div/shares = 280/200 = 1.4
ret = (DPS+ch_P)/P_1 => 12.5% = (1.4 + P0-28.5)/28.5 => P0=30.66
ch_P/P_1 = (P0-P_1)/P_1 = (30.6-28.5)/28.5 = 7.59%

Question 44
Caterpillar Inc. has 8 million shares of common stock outstanding, and 1.5 million 8% percent
semi-annual bonds outstanding, par value $100 each. The common stock currently sells for
$25 per share, and has a beta of 1.25, and the bonds have 10 years to maturity and sell for

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93% of par. Cost of debt is 9.08%. The market risk premium is 10%, the return on risk free
rate is 4.5%, and tax rate is 30%.
a) What is the firm’s market value of debt and equity?
b) Caterpillar is evaluating a new investment project that has the same risk as the overall firm,
what is the rate that the firm should use to discount the project’s cash flows?
Answer: a) 139.5m, 200m; b) 12.63%
MV of equity = #shares × price = 8m × 25 = $200m
MV of debt = 1.5m × $93 = $139.5
E(Rm)-Rf = 0.10; Rf= 0.045; Beta= 1.25
 CAPM: E(R) = 0.045 + 1.25(0.10) = 0.17
Cost of debt = YTM = 9.08%
WACC = (200/339.5)(0.17) + (139.5/339.5)(0.0908)(1-0.3) = 0.1263

Question 45
The fixed costs of a project are $8,000. The depreciation expense is $3,500 and the operating
cash flow is $20,000. What is the degree of operating leverage for this project?
Answer: 1.40

Question 46
Jack’s Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds
with similar characteristics are yielding 8.5 %. Face value of a bond is $1000. The company
also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells
for $40 a share. The U.S. Treasury bill is yielding 4 % and the market risk premium is 8 %.
Jack’s tax rate is 35 %. What is Jack’s weighted average cost of capital?
Answer: 10.38 %

Question 47
Stark company has decided to restructure its capital. Currently, it uses no debt financing.
Following the restructuring, debt will be $1 million. The interest rate on the debt will be 9%.
The company currently has 200 000 shares outstanding and the price per share is $20. If the
restructuring is expected to increase EPS, what is the minimum level of EBIT that the firm’s
management must be expecting?
Answer: $360 000

Question 48
Strip Tavern has the cost of equity at 14% and the cost of debt at 6.5%. Assuming that the
target debt/equity ratio is 50% and the company tax rate is 34%, calculate the overall cost of
capital.
Answer: 10.7%

Question 48b
The Can-Do Co. is analysing a proposed project. The company expects to sell 12,000 units,
plus or minus 4 percent. The expected variable cost per unit is $7 and the expected fixed cost
is $36,000. The fixed and variable cost estimates are considered accurate within a plus or
minus 6 percent range. The depreciation expense is $30,000 per year, over the 5 year life of
the project, using the straight line. The tax rate is 34 percent. The sale price is estimated at
$14 a unit, plus or minus 5 percent.
a) What is the earnings before interest and taxes under the base case scenario?

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b) What is the earnings before interest and taxes under a best case scenario?
c) What is the net income under the worst case scenario?
d) What is the NPV under the base case scenario if required rate of return is 12%?
Answer: a) $18 000; b) $37,497.60; c) -$278.78; d) $968.03

Question 49
You purchased 200 shares of stock at a price of $36.72 per share. Over the last year, you have
received total dividend income of $322. What is the dividend yield?
Answer: 4.4%

Question 50
Printing Equip Co. are considering a project that costs $180 000, has a 6 year life, and no
salvage value. Assume that depreciation is straight line. The required return of Printing Equip
is 10.5% on such projects. Sales are estimated at 28 000 units per year. Price per unit is $9,
variable cost per unit is $3.20, and fixed costs are $35 000 per year. The tax rate is 35%.
 What is the accounting break-even point?
 Calculate the base case cash flow and NPV
 What is the degree of operating leverage?
 Suppose that you think that the sales projection is accurate only to within 15%. Evaluate
the sensitivity of NPV to changes in that projection by showing the NPV in the best and
worst case.
 Suppose the projections given are all accurate to within 4% except for sales volume,
which is only accurate to within 10%. What are the upper and lower bounds for these
projections?
Answer:
a) 11,207 units; b) $93,310, $220,503; c) 1.375; d) $288 466, $152 541
e) Apply 10% to sales and 4% to the rest of variables.

Question 51
The Auto Group has 1,200 bonds outstanding that are selling for $980 each. Face value is
$1000. The company also has 7,500 shares of preferred stock at a market price of $40 each.
The common stock is priced at $32 a share and there are 32,000 shares outstanding. What is
the weight of the preferred stock as it relates to the firm’s weighted average cost of capital?
Answer: 12%

Question 52
Telco Inc. has a beta of 1.3 and an expected return of 18%. Woollies Co. has a beta of 0.80
and an expected return of 9.5%. If Treasury Bills yield a return of 5% and the market return is
11.75%, which stock is under/overvalued relative to the other? Show why.
Answer: Telco is undervalued relative to Woollies.

Reward to risk ratio for each stock: [ E(r) – Rf ] / 

Telco: ( 0.18 – 0.05 ) / 1.3 = 0.10
Woolies: ( 0.095 – 0.05 ) / 0.8 = 0.05625
=> Woolies is overvalued, Telco is undervalued

Examples of Short Questions in the exam:

What is the Portfolio Theory assumption?

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Investors prefer the portfolio with the highest expected return for a given variance, or, the
lowest variance for a given expected return

Discuss the information effect or the signalling effect of dividends.

Dividends and Signals
Asymmetric information – managers have more info about the health of the company than investors
Information Content Effect > Changes in dividends convey information > Cause market reaction
- Dividend increases: Management believes it can be sustained, Expectation of higher future dividends,
increasing present value, Signal of a healthy, growing firm
- Dividend decreases: Management believes it can no longer sustain the current level of dividends,
Expectation of lower dividends indefinitely; decreasing PV, Signal of a firm that is having financial
difficulties

Explain and graphically show, together with the associated formulas, the M&M proposition I
and II with taxes.
Optimal capital structure is almost 100% debt, each additional dollar of debt increases the
CFA of firm

What are some examples of direct bankruptcy costs?

Administrative and legal costs

According to the CAPM, the expected return on a risky asset depends on three components.
Describe each component, and explain its role in determining expected return.
1. The risk-free rate, Rf
2. The market risk premium, E(RM) Rf
3. The systematic risk of the asset relative to average, which we called its beta coefficient,

Explain the concept of ‘homemade dividend policy’.

Homemade Dividend Policy
Investors will not pay higher prices for firms with higher dividend payouts.
In other words, dividend policy will have no impact on the value of the firm because investors can
create whatever income stream they prefer by using homemade dividends.
Homemade Dividend Policy = Tailored dividend policy created by individual investors to undo
corporate dividend policy

Discuss and graphically show with the associated formulas the Capital Structure Theory when
the firm has debt but not taxes.
There is no optimal capital structure in this case, as the capital structure has no influence on
the firms value, without taxes, the total value is unaffected by its capital structure

What are some real-world factors that may cause one dividend policy to be preferable to
another?
Different Tax rates, flotation costs, dividend restrictions, desire for current income,
uncertainty resolution

What is diversification? What is the variable that plays the most important role in reducing
the portfolio risk?
The Principle of Diversification:
states that spreading an investment across many assets will eliminate some but not all of the risk.
Diversification can substantially reduce the variability of returns without an equivalent reduction in
expected returns
Size of risk reduction depends on covariances between assets in the portfolio
there is a minimum level of risk that cannot be diversified away and that is the systematic portion
Unsystematic risk is essentially eliminated by diversification, but systematic risk cannot be reduced by
a portfolio

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Define the three forms of market efficiency. What do we mean when we say the markets are
efficient?
Capital Market Efficiency
Efficient Capital Markets: A market in which security prices reflect available information → based on
available information, there is no reason to believe that the current price is too low or too high.
efficient markets hypothesis (EMH): The hypothesis that actual capital markets, such as the NYSE, are
efficient.
It means that, on average, you will earn a return that is appropriate for the risk undertaken and there is
not a bias in prices that can be exploited to earn excess returns
3 forms:
- weak form efficiency: - Prices reflect all past market information such as price and volume
- investors cannot earn abnormal returns by trading on market information
- Implies that technical analysis will not lead to abnormal returns
- Empirical evidence indicates that markets are generally wfe
- semistrong form efficiency: - Prices reflect all publicly available information including trading
information, annual reports, press releases, etc.
- investors cannot earn abnormal returns by trading on public
information
→ fundamental analysis will not lead to abnormal returns
- strong form efficiency: - Prices reflect all information, including public and private
- investors could not earn abnormal returns regardless of the information
they possessed
- Empirical evidence indicates that markets are NOT strong form efficient
and that insiders could earn abnormal returns

What are the lessons learned from capital market history?

Lessons from Capital Market History
- Data reflects two features often observed in financial markets: - There is a reward for bearing risk.
- The larger the potential reward, the larger the risk.
- This is called the risk-return trade-off
- There is a positive relationship between risk and return

Explain the meaning of the dividend clientele effect and why it is important.
Clientele Effect
Some investors prefer low dividend payouts and will buy stock in those companies that offer low
dividend payouts
Some investors prefer high dividend payouts and will buy stock in those companies that offer high
dividend payouts
→ If a firms changes the dividend policy from low to high or vice versa, it doesn’t matter, it just
changes its structure of investors

What are the components of total risk? Give examples of each.

Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure of total risk
For well-diversified portfolios, unsystematic risk is very small → almost = to the systematic risk
Systematic or unsystematic Risk
Systematic or Non-Diversifiable Risk, market risk: That portion of an asset’s risk attributed to the
market factors that affect all firms and cannot be eliminated through the process of diversification.
Unsystematic or Diversifiable Risk asset-specific risk: That portion of an asset’s risk which is firm
specific and can be eliminated through the process of diversification

What is CAPM? In equilibrium, what does CAPM implies?

Shows the relationship between systematic risk and expected return
Positive slope
The higher the risk, the higher the return
According to the CAPM, all stocks must lie on the SML, otherwise they would be under or overpriced.
In equilibrium, all assets and portfolios must have the same reward-to-risk ratio and they all must equal
the reward-to risk ratio for the market, If not, assets are undervalued or overvalued

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What are other approaches of estimating the cost of capital of a project when the project is not
of the same risk as the overall risk of the firm?
Other approaches to estimating a discount rate:
- divisional cost of capital—used if a company has more than one division with different levels of risk;
- pure play approach —a discount rate that is unique to a particular project is used;
Look at companies in the same line of business as the new project
Calculate an average WACC for all the companies and use this rate as the discount rate of the new
project
- subjective approach —projects are allocated to specific risk classes which, in turn, have specified
discount rates
Consider the project’s risk relative to the firm overall risk
If the project risk > firm risk, use a discount rate > WACC
If the project risk < firm risk, use a discount rate < WACC

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