UOW COLLEGE HONG KONG

Course code & Title : BUS20269 Financial Management

Time allowed : Three hours

This paper has SEVEN pages (including this cover page).

1. This paper consists of 2 sections.

a. Section A: Answer ALL questions (70 marks)
b. Section B: Answer any THREE questions (30 marks)

2. Write down your answers in the answer book.

NOT TO BE TAKEN AWAY

This is a closed-book examination.

Candidates are allowed to use the following materials/aids:

Approved Calculators are allowed

Materials/aids other than those stated above are not permitted. Candidates will be
subject to disciplinary action if any unauthorized materials or aids are found on them.

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 Section A
Attempt ALL questions from this Section – Marks: 70

Question A1 – Financial Statements, Taxes and Cash Flow (10 marks)

A1. Home Supply, Inc. has compiled the following information:

Find out the following for 2010:

i) Operating Cash Flow; (1 mark)

ii) Change in Net Working Capital; (1 mark)
iii) Net Capital Spending; (1 mark)
iv) Cash Flow From Assets; (1 mark)
v) Cash Flow to Creditors; (1 mark)
vi) Addition to retained earnings; (1 mark)
vii) Net income; (1 mark)
viii) Dividends paid; (1 mark)
ix) Cash Flow to Stockholders. (2 marks)

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Question A2 – Discounted Cash Flow Valuation (10 marks)

A2. Chandler Tire Co. is trying to decide which one of two projects it should accept. Both
projects have the same start-up costs. Project 1 will produce annual cash flows of $52,000 a
year for 6 years. Project 2 will produce cash flows of $48,000 a year for 8 years. The company
requires a 15 percent rate of return.

i) What is the present value of project 1’s cash flow? (4 marks)

ii) What is the present value of project 2’s cash flow? (4 marks)

iii) Which project should the company select and why? (2 marks)

Question A3 – Interest rate and Bond valuation (10 marks)

A3. Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.50%, a
maturity premium of 0.20% per year to maturity applies, i.e., Maturity Premium = 0.20%(t),
where t is the years to maturity [which means, Maturity Premium = 0.20% times t years].
Suppose also that a liquidity premium of 0.50% and a default risk premium of 0.80% applies
to A-rated corporate bonds.

i) What is the maturity premium of the 5-year A-rated corporate bond? (2 marks)
ii) What is the maturity premium of the 10-year Treasury bond? (2 marks)
iii) What is the yield (i.e. the required return) on a 5-year A-rated corporate bond?
(3 marks)
iv) What is the yield (i.e. the required return) on a 10-year Treasury bond?
(3 marks)

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Question A4 - Capital Budgeting (10 marks)

A4. You are considering the following two mutually exclusive projects that will not be
repeated. The required rate of return is 11.25% for project A and 10.75% for project B. Which
project should you accept and why?

i) Calculate the Payback period of both projects. (2

marks)

ii) State one advantage and one disadvantage of Payback period rule?
(2 marks)

iii) Calculate the IRR of both projects. (2 marks)

iv) Under what circumstances IRR may generate wrong decision? (1 mark)

v) Calculate the NPV of both projects (2 marks)

vi) Which project should you accept and what is the best reason for that decision?
(1 mark)

Question A5 – Business and Financial Risk (10 marks)

A5. Assume a firm’s debt is risk-free, so that the cost of debt equals the risk-free rate, Rf.
Define bA as the firm’s asset beta – that is, the systematic risk of the firm’s assets. Define bE
to be the beta of the firm’s equity. Use the capital asset pricing model (CAPM) along with
M&M Proposition II to show that bE = bA x (1 + D/E), where D/E is the debt/equity ratio.
Assume the tax rate is zero.
(10 marks)

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Question A6 - Risk and Return II (10 marks)
A6. Consider following portfolio:

Portfolio Industry Expected Return Standard Derivation

Weight

Stock A (30%) Financial 16%p.a. 30%p.a.

Stock B (40%) Technology 18% p.a. 25%p.a.

Stock C (20%) Tobacco 12% p.a. 15%p.a.

Stock D (10%) Utilities 7% p.a. 5%p.a.

i) Calculate the expected return of above portfolio. (1 mark)

ii) What is the purpose of diversification? Is it possible to diversify away all the risk?
(3 marks)
iii) The expected return of Stock B (18%p.a.) is higher than that of Stock A (16%p.a.),
while the standard deviation of Stock B (25%p.a.) is less than that of Stock A
(30%p.a.). Does it violate the risk-return tradeoff principle? Justify your answer.
(2 marks)

iv) Does the portfolio standard derivation equal to 22.5%p.a.? Justify your answer
with appropriate assumption.
(4 marks)

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Question A7 – Cost of Capital (10 marks)

A7. Given the following information for Hung & Wong Transport, find the cost of capital.
Assume the company's tax rate is 35 percent.

Debt: 7,500, 8.4 percent coupon bonds outstanding. $1,000 par value, 22 years to maturity,
selling for 103 percent of par, the bonds make semiannual payments.

Common stock: 195,000 shares outstanding, selling for $78 per share, beta is 1.21.

Preferred stock: 11,000 shares of 6.35 percent preferred stock outstanding, currently selling
for $76 per share.

Market: 8 percent market risk premium and 5.1 percent risk-free rate.

i) Calculate the market value of common stock, preferred stock, bond and the total
market value of the firm. (2 marks)

ii) Calculate the cost of common stock.

(1 mark)
iii) Calculate the cost of preferred stock.
(1 mark)
iv) Calculate the (i) before tax cost of the debt and (ii) after tax cost of debt.
(2 marks)
v) Calculate the weight of common stock (wE), weight of preferred stock (wP) and the
weight of the debt (wD) in the total capital.
(3 marks)
vi) Calculate the weighted average of cost of capital (WACC).
(1 mark)

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 Section B
Attempt any THREE questions from this Section – Marks: 30

Question B1 (10 marks)

B1. Explain the concept of the pure play approach to assigning a required return to a project,
illustrate the steps with an example (8 marks). Give one disadvantage of the pure play
approach (2 marks).

Question B2 (10 marks)

B2. Miller Tool is a successful manufacturer of both consumer and industrial hand tools and
is publicly owned. The firm has several positive net present value projects that it would like
to pursue and thus decided to issue additional of common stock shares through the
Seasoned Equity Offering (SEO). As a result of this stock issue, the firm's stock price declined.
Explain why this occurred when the proceeds of the issue are being used to fund positive net
present value projects.
(10 marks)

Question B3 (10 marks)

B3. Other than real interest rates, inflation premium and default risk premium, list and
explain other THREE factors that may affect the required return of the bonds.
(10 marks)

Question B4 (10 marks)

B4. Todd wants to start his own business and is debating between organizing the business as
a sole proprietorship or a corporation. Explain the THREE pros and TWO cons of the sole
proprietorship; as well as THREE pros and TWO cons of the corporation. (10 marks)

Question B5 (10 marks)

B5. Since there are no perfect or ideal standard ratios for a firm, why is ratio analysis still
considered a valuable management tool? (10 marks)

Question B6 (10 marks)

B6. Rank the (i) historical returns and (ii) risk of following investments from year 1925
through 2011: a. Large company stocks; b. Small company stocks; c. Long-term government
bonds; and d. Short-term government bonds, from the highest to the lowest. (8 marks)
What are the lessons learnt from the capital market history? (2 marks)

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