MIDTERM EXAMINATION

Spring 2010

MGT201- Financial Management (Session - 3)

Question No: 1 ( Marks: 1 ) - Please choose one

Which of the following statements is correct for a sole proprietorship?

► The sole proprietor has limited liability

► The sole proprietor can easily dispose of their ownership position relative to a shareholder in a corporation

► The sole proprietorship can be created more quickly than a corporation

► The owner of a sole proprietorship faces double taxation unlike the partners in a partnership

Question No: 2 ( Marks: 1 ) - Please choose one

Which of the following market refers to the market for relatively long-term financial instruments?

► Secondary market

► Primary market

► Money market

► Capital market

Question No: 3 ( Marks: 1 ) - Please choose one

Felton Farm Supplies, Inc., has an 8 percent return on total assets of Rs.300,000 and a net profit margin of 5 percent. What are its sales?

► 750,0Rs.3, 750,000

► Rs.48Rs.480, 000

► Rs.30Rs.300, 000

► Rs.1, Rs.1, 500,000

Solution:

Since ROI=8% on $300,000 of assets,

then net profit is $24,000 (8% × $300,000).

Using the net profit and

given that the NPM=5%,

sales equals $480,000 ($24,000 / 5%).

Question No: 4 ( Marks: 1 ) - Please choose one

An investment proposal should be judged in whether or not it provides:

► A return equal to the return require by the investor

► A return more than required by investor

► A return less than required by investor

► A return equal to or more than required by investor

Question No: 5 ( Marks: 1 ) - Please choose one

A capital budgeting technique through which discount rate equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow is known as:

► Payback period

► Internal rate of return

► Net present value

► Profitability index

Question No: 6 ( Marks: 1 ) - Please choose one

A capital budgeting technique that is NOT considered as discounted cash flow method is:

► Payback period

► Internal rate of return

► Net present value

► Profitability index

Question No: 7 ( Marks: 1 ) - Please choose one

Why net present value is the most important criteria for selecting the project in capital budgeting?

► Because it has a direct link with the shareholders dividends maximization

► Because it has direct link with shareholders wealth maximization

► Because it helps in quick judgment regarding the investment in real assets

► Because we have a simple formula to calculate the cash flows

Question No: 8 ( Marks: 1 ) - Please choose one

You are selecting a project from a mix of projects, what would be your first selection in descending order to give yourself the best chance to add most to the firm value, when operating under a single-period capital-rationing constraint?

► Profitability index (PI)

► Net present value (NPV)

► Internal rate of return (IRR)

► Payback period (PBP)

Question No: 9 ( Marks: 1 ) - Please choose one

Bond is a type of Direct Claim Security whose value is NOT secured by __________.

► Tangible assets

► Intangible assets

► Fixed assets

► Real assets

Question No: 10 ( Marks: 1 ) - Please choose one

If a 7% coupon bond is trading for Rs. 975 it has a current yield of _________ percent.

► 7.00

► 6.53

► 8.53

► 7.18

Reference:

Current Yield = Coupon / Market Price

Current Yield = 7%*1000/ 975

Current Yield = 70/ 975

Current Yield = 0.071*100

Current Yield = 7.18

Question No: 11 ( Marks: 1 ) - Please choose one

Which of the following is designated by the individual investor's optimal portfolio?

► The point of tangency with the opportunity set and the capital allocation line

► The point of highest reward to variability ratio in the opportunity set

► The point of tangency with the indifference curve and the capital allocation line

► The point of the highest reward to variability ratio in the indifference curve

Question No: 12 ( Marks: 1 ) - Please choose one

Assume that the expected returns of the portfolios are the same but their standard deviations are given in the options given below, which of the option represent the most risky portfolio according to standard deviation?

► 1.5%

► 2.0%

► 3.0%

► 4.0%

Solution:

G= plowback ratio x ROE.

40% earning retained

60% remaining

G=0.60 x 0.10 = 0.06*100=6%

Question No: 13 ( Marks: 1 ) - Please choose one

Which of the following is a drawback of percentage of sales method?

► It is a rough approximation

► There is change in fixed asset during the forecasted period

► Lumpy assets are not taken into account

► All of the given options

Question No: 14 ( Marks: 1 ) - Please choose one

Which of the following need to be excluded while we calculate the incremental cash flows?

► Depreciation

► Sunk cost

► Opportunity cost

► Non-cash item

Question No: 15 ( Marks: 1 ) - Please choose one

Which of the following is NOT an example of a financial intermediary?

► Wisconsin S&L, a savings and loan association

► Strong Capital Appreciation, a mutual fund

► Microsoft Corporation, a software firm

► College Credit, a credit union

Question No: 16 ( Marks: 1 ) - Please choose one

An 8% coupon Treasury note pays interest on May 30 and November 30 and is traded for settlement on August 15. What is the accrued interest on Rs. 100,000 face value of this note?

► Rs. 491.80

► Rs. 800.00

► Rs. 983.61

► Rs. 1,661.20

Reference

:Approximation: .08/12*100,000=666.67 per month. 666.67/month * 2.5 months = 1,666.67.

Question No: 17 ( Marks: 1 ) - Please choose one

A preferred stock will pay a dividend of Rs. 3.50 in the upcoming year, and every year thereafter, i.e., dividends are not expected to grow. You require a return of 11% on this stock. Use the constant growth model to calculate the intrinsic value of this preferred stock.

► Rs. 0.39

► Rs. 0.56

► Rs. 31.82

► Rs. 56.25

Reference:

PV = DIV1/ rPE

= 3.5 / 11%

= 3.5/0.11

= Rs 31.82

Question No: 18 ( Marks: 1 ) - Please choose one

Information that goes into __________ can be used to prepare __________.

► A forecast balance sheet; a forecast income statement

► Forecast financial statements; a cash budget

► Cash budget; forecast financial statements

► A forecast income statement; a cash budget

Question No: 19 ( Marks: 1 ) - Please choose one

What is the present value of Rs.8,000 to be paid at the end of three years if the interest rate is 11% compounded annually?

► Rs.5,850

► Rs.4,872

► Rs.6,725

► Rs.1,842

Solution:

FV = PV(1+ i)

PV = FV/(1+i)

PV = 8,000/(1+0.11)^3

PV = 5,850

Question No: 20 ( Marks: 1 ) - Please choose one

“Do not compare apples with oranges” is the concept in:

► Discounting and Net present value

► Risk & return

► Insurance management

► Time value of money

Question No: 21 ( Marks: 1 ) - Please choose one

Which of the following is NOT the interest rate used for discounting calculation?

► Benchmark interest rate

► Effective interest rate

► Periodic interest rate

► Nominal interest rate

Question No: 22 ( Marks: 1 ) - Please choose one

Which of the following is the formula to calculate the future value of perpetuity?

► Constant cash flows × interest rate

► Constant cash flows / interest rate

► Constant cash flows + Constant cash flows × interest rate

► Constant cash flows - Constant cash flows/ interest rate

Question No: 23 ( Marks: 1 ) - Please choose one

Which of the following interest rate keeps on moving and changing on daily basis?

► Book value

► Market value

► Salvage value

► Face value

Question No: 24 ( Marks: 1 ) - Please choose one

From which of the following formula we can calculate coupon rate?

► Coupon receipt / market value

► Coupon receipt / present value

► Coupon receipt / salvage value

► Coupon receipt / book value

Question No: 25 ( Marks: 1 ) - Please choose one

Value of “g” in the formula of constant growth rate can be calculated from which of the following formula?

► g = plowback ratio × ROE

► g = plowback ratio × ROA

► g = payout ratio + ROE

► g = payout ratio + ROA

Question No: 26 ( Marks: 1 ) - Please choose one

In Gordon’s formula (rCE = DIV1 / Po + g), rCE is considered as __________ and “g” is considered as __________.

► Dividend yield, operating expenses

► Dividend yield, operating income

► Dividend yield, capital loss

► Dividend yield, capital gain

Question No: 27 ( Marks: 1 ) - Please choose one

To calculate the annual rate of return for an investment, we require which of the following(s)?

► The income created

► The gain or loss in value

► The original value at the beginning of the year

► All of the given options

Question No: 28 ( Marks: 1 ) - Please choose one

This is an example of which of the following?

Real estate prices fell across the board because the market was glutted with surplus pre-owned homes for sale.

► Economic risk

► Industry risk

► Company risk

► Market risk

Question No: 29 ( Marks: 3 )

Briefly explain what call provision is and in which case companies use this option.

Call Provision:

The right (or option) of the Issuer to call back (redeem) or retire the bond by paying-off the Bondholders before the Maturity Date. When market interest rates drop, Issuers (or Borrowers) often call back the old bonds and issue new ones at lower interest rates

Question No: 30 ( Marks: 3 )

There are two stocks in the portfolio of Mr. N, Stock A and Stock B. the information of this portfolio is as follows:

Common stock Expected rate of return Standard deviation

Stock A 15% 10%

Stock B 20% 15%

Calculate the expected rate of return on this portfolio assuming that Stock A consists of 75% of the total funds invested in the stocks and the remainder in Stock B.

Solution:

formula on page 93 of handouts.

(XA2 σ A 2 +XB2 σ B 2 + 2 (XA XB σ A σ B ϱ AB) x (0.5)

={(75/100)2(10/100)2+(25/100)2(15/100)2+2((75/100)(25/100)(10/100)(15/100)(.6)}(.5)

= {(0.5625)(0.01)+(.0625)(0.0225)+2((.75)(.25)(.1)(.15)(.6))}(.5)

=(0.010406)*.5

=0.005203*100

=0.520313%

Question No: 31 ( Marks: 5 )

(a) What is correlation of coefficient?

Solution:

Correlation Coefficient ( AB or “Ro”):

Risk of a Portfolio of only 2 Stocks A & B depends on the Correlation between those 2 stocks.

The value of Ro is between -1.0 and +1.0

If Ro = 0 then Investments are Uncorrelated & Risk Formula simplifies to Weighted Average

Formula. If Ro = + 1.0 then Investments are Perfectly Positively Correlated and this means that

Diversification does not reduce Risk.

If Ro = - 1.0, it means that Investments are Perfectly Negatively Correlated and the Returns (or Prices or Values) of the 2 Investments move in Exactly Opposite directions. In this Ideal Case, All Risk can be diversified away. For example, if the price of one stock increases by 50% then the price of another stock goes down by 50%.

In Reality, Overall Ro for most Stock Markets is about Ro = + 0.6.it is very rough rule of thumb. It means that correlations are not completely perfect and you should remember that if the correlation coefficient is +1.0 then it is not possible to reduce the diversifible risk.

This means that increasing the number of Investments in the Portfolio can reduce some amount of risk but not all risk

(b) What are efficient portfolios?

Solution:

Efficient Portfolios are those whose Risk & Return values match the ones computed using Theoretical Probability Formulas. The Incremental Risk Contribution of a New Stock to a Fully

Diversified Portfolio of 40 Un-Correlated Stocks will be the Market Risk Component of the New Stock only. The Diversifiable Risk of the New Stock would be entirely offset by random movements in the other 40 stocks. Adding a New Stock to the existing Portfolio will create more Efficient Portfolio Curves. The New Stock will contribute its own Incremental Risk and Return to the Portfolio.

Question No: 32 ( Marks: 5 )

Suppose you approach a bank for getting loan. And the bank offers to lend you Rs.1, 000,000 and you sign a bond paper. The bank asks you to issue a bond in their favor on the following terms required by the bank: Par Value = Rs 1, 000,000, Maturity = 3 years

Coupon Rate = 15% p.a, Security = Machinery

You are required to calculate the cash flow of the bank which you will pay every month as well as the present value of this option.

Data:

Par Value = Rs 1, 000,000

Maturity = 3 years

Coupon Rate = 15% p.a,

Security = Machinery

Solution:

CF = Cash Flow = Coupon Value = Coupon Rate x Par Value

CF = 15% x 1,000,000

CF = 150000/12

Monthly CF = 12500

Assume that rD = 10%

PV = CF1/(1+rD/12)12+CFn/(1+rD/12)2x12 +..+CFn/ (1+rD/12) n +PAR/ (1+rD) n

PV = 12500/ (1 + 0.10/12)12 + 12500/ (1 + 0.10/12)2x12 + 12500/ (1 + 0.10/12)3x12 + 1000000/(1 + 0.10/12)3x12

PV = 12500/ (1.00833)12 + 12500/ (1.00833)24 + 12500/ (1.00833)36 + 1000000/(1.00833)36

PV = 11315.60425 + 10243.43196 + 9272.849775 + 741828

PV = 772660

FV = CCF (1 + rD/m )nxm - 1/rD/m

FV = 12500 (1 + 10%/12)3x12 - 1 / 10%/12

FV = 12500 (41.779)

FV = 522237.5

PV (Coupons Annuity) = FV / (1 + rD/m) nxm

PV = 522237.5/(1 + 10%/12) 3x12

PV = 522237.5/1.348021407

PV = 387410

PV (Par) = 1,000,000 / (1.00833)36

PV (Par) = 741828

PV = PV (Coupons Annuity) + PV (Par)

PV = 387410 + 741828

PV = 1129238