Pexam1

ADVANCED CORPORATE FINANCE [FN2] PRACTICE EXAMINATION #1 (Updated to the 2012/2013 module notes) FN2 Before starting to write the examination, make sure that it is complete and that there are no printing defects. This examination consists of 5 pages and 26 pages of attachments. There are 6 questions for a total of 100 marks. READ THE QUESTIONS CAREFULLY AND ANSWER WHAT IS ASKED. To assist you in answering the examination questions, CGA-Canada includes the following glossary of terms. Glossary of Assessment Terms Adapted from David Palmer, Study Guide: Developing Effective Study Methods (Vancouver: CGA-Canada, 1996). Copyright David Palmer. Calculate Mathematically determine the amount or number, showing formulas used and steps taken. (Also Compute). Compare Examine qualities or characteristics that resemble each other. Emphasize similarities, although differences may be mentioned. Contrast Compare by observing differences. Stress the dissimilarities of qualities or characteristics. (Also Distinguish between) Criticize Express your own judgment concerning the topic or viewpoint in question. Discuss both pros and cons. Define Clearly state the meaning of the word or term. Relate the meaning specifically to the way it is used in the subject area under discussion. Perhaps also show how the item defined differs from items in other classes. Describe Provide detail on the relevant characteristics, qualities, or events. Design Create an outcome (e.g., a plan or program) that incorporates the relevant issues and information. Determine Calculate or formulate a response that considers the relevant qualitative and quantitative factors. Diagram Give a drawing, chart, plan or graphic answer. Usually you should label a diagram. In some cases, add a brief explanation or description. (Also Draw) Discuss This calls for the most complete and detailed answer. Examine and analyze carefully and present both pros and cons. To discuss briefly requires you to state in a few sentences the critical factors. Evaluate This requires making an informed judgment. Your judgment must be shown to be based on knowledge and information about the subject. (Just stating your own ideas is not sufficient.) Cite authorities. Cite advantages and limitations. Explain In explanatory answers you must clarify the cause(s), or reasons(s). State the “how” and “why” of the subject. Give reasons for differences of opinions or of results. To explain briefly requires you to state the reasons simply, in a few words. Identify Distinguish and specify the important issues, factors, or items, usually based on an evaluation or analysis of a scenario. Illustrate Make clear by giving an example, e.g., a figure, diagram, or concrete example. Interpret Translate, give examples of, solve, or comment on a subject, usually making a judgment on it. Justify Prove or give reasons for decisions or conclusions. List Present an itemized series or tabulation. Be concise. Point form is often acceptable. Outline This is an organized description. Give a general overview, stating main and supporting ideas. Use headings and sub-headings, usually in point form. Omit minor details. Prove Establish that something is true by citing evidence or giving clear logical reasons. Recommend Propose an appropriate solution or course of action based on an evaluation or analysis of a scenario. Relate Show how things are connected with each other or how one causes another, correlates with another, or is like another. Review Examine a subject critically, analyzing and commenting on the important statements to be made about it. State Clearly provide a position based on an evaluation, e.g., Agree/Disagree, Correct/Incorrect, Yes/No. (Also Indicate) Summarize Give the main points or facts in condensed form, like the summary of a chapter, omitting details and illustrations. Trace In narrative form, describe progress, development, or historical events from some point of origin. PEFN2#1  CGA-Canada Page 1 of 5 CGA-CANADA ADVANCED CORPORATE FINANCE [FN2] EXAMINATION PRACTICE EXAMINATION #1 (Updated to the 2012/2013 module notes) Marks Time: 4 Hours Notes: 1. Questions 1 and 2 are multiple choice. For these questions, select the best answer for each of the unrelated items. Answer each of these items in your examination booklet by giving the number of your choice. For example, if the best answer for item (a) is (1), write (a)(1) in your examination booklet. If more than one answer is given for an item, that item will not be marked. Incorrect answers will be marked as zero. Marks will not be awarded for explanations. 2. Except for multiple-choice questions, answers should include all supporting calculations where appropriate. 3. If you provide alternative answers to Questions 3, 4, 5, or 6, only the first answer will be marked. If you wish to change your answer, you must cross out the answer you do not wish to submit for marking. 12 Question 1 Note: 2 marks each a. Which of the following is least likely to have increased market efficiency? 1) Advances in computer and telecommunications technology 2) Government regulations to reform market trading by insiders 3) Corporate investments in private derivative securities 4) The campaign for rights by some shareholder activists b. Which of the following will most likely increase agency costs? 1) Managers’ compensation plans that are linked to the performance of a firm’s share prices 2) Corporate mergers and acquisitions 3) An independent board of directors 4) A generous severance package for executives c. Which of the following is least likely to be included in a long-term financial plan? 1) Sales forecast 2) Pro forma income statement 3) Pro forma cash flow statement 4) Cash budget d. Which of the following statements about valuation of a company is false? 1) The APV method of discounting can be used with operating cash flows. 2) The WACC method of discounting can be used with free cash flows to equity. 3) Operating cash flows include changes in working capital. 4) Free cash flows to equity consider financing cash flows. e. Which of the following is used to evaluate the consistency of various financial policies? 1) Operating plan 2) Cash budget 3) Sales forecast 4) Pro forma financial statements Continued... PEFN2#1  CGA-Canada Page 2 of 5 f. Which of the following is the most appropriate rate for discounting in lease-versus-purchase decisions? 1) The after-tax cost of debt 2) The cost of unlevered equity 3) The cost of levered equity 4) The discount rate for dividends 18 Question 2 Note: 3 marks each a. What is the effective annual interest rate on a discount term loan at a 7.5% interest rate compounded monthly? 1) 7.714% 2) 7.776% 3) 7.814% 4) 7.865% b. ABC Corp. pays out all its earnings as dividends, and has just paid a dividend of $5.06. These dividends are expected to grow at 4% per year, and there are 100,000 shares outstanding. If the value of the company is $6,578,000, which of the following is true? 1) The levered cost of equity is 12.0%. 2) The WACC is 10.5%. 3) The financial side effects add 3.5% to the value. 4) The unlevered cost of equity is 11.2%. c. DJM Corp. is to issue $80 million face value of six-month commercial paper in three months. If issued today, the commercial paper would sell at an interest rate of 3%. However, interest rates will likely increase in the next three months. The correlation between changes in the yields on DJM’s commercial paper and those on bankers’ acceptances (BA) is 0.95. DJM would like to hedge against this interest rate risk by selling three-month BA futures contracts. A standard contract has a $1 million face value. How many contracts should DJM sell in this situation? 1) 76 2) 150 3) 152 4) 158 d. JKL Corp. needs $5 million to finance its working capital. NMD Bank offers a discount interest term loan with a 5% annual interest rate and a compensating balance of 7%. What amount should JKL borrow in order to obtain the desired funds? 1) $5.0000 million 2) $5.3191 million 3) $5.6818 million 4) $5.7471 million e. TC Bakery bought June call options for wheat with an exercise price of $2.75 at a premium of $0.10 per bushel. If the price of wheat at the expiration is $2.95, what is the cost of one bushel of wheat for TC? 1) $0.10 2) $2.75 3) $2.85 4) $2.95 Continued... PEFN2#1  CGA-Canada Page 3 of 5 f. A stock portfolio with $100,000 market value and a price change standard deviation of 15% per year has an approximately normal price change distribution. What is the 95% value at risk during the next year? 1) $24,675 2) $75,325 3) $85,000 4) $164,500 18 Question 3 BC Ferris Co. (BCF), an all-equity-financed company, expects its after-tax earnings to be $100 million in perpetuity. With 10 million shares outstanding, BCF’s earnings are $10 per share. The shareholders’ required rate of return on their equity is 10%. BCF adopts a 100% dividend payout policy. After the ex-dividend period date, BCF announces that it has identified a project to expand its business. The project does not change the firm’s risk, and BCF plans a rights offering to raise the $100 million required to undertake this project. The project will generate earnings before interest and taxes of $30 million per year in perpetuity. BCF has a corporate tax rate of 40% and the rights entitle the holder to purchase BCF shares at $80 per share. Required Write a memo to advise Jack, a representative of current shareholders, whether he should participate in this rights offering. Answer questions (a) to (f) in your memo: 2 a. Calculate the value of the firm before BCF’s announcement. Calculate the share price. Assume that the market is efficient. 3 b. Determine the net present value of the project and the value of the firm after BCF’s announcement. Determine the share price after the announcement. 3 c. Determine how many new shares have to be issued to raise $100 million in this rights offering and how many rights are required to purchase each new share. 2 d. Calculate the theoretical value of a right during the rights-on period and during the ex-rights period. 1 e. Calculate the share price during the ex-rights period. 3 f. Explain why a rights offering is considered to give shareholders “pre-emptive rights.” Indicate whether Jack should participate in the rights offering. Note: 1 mark for memo communication skills: format, tone, logic, and clarity. 4 g. Suppose BCF goes ahead with the capital investment, and has financed it with the rights issue. Senior executives and the board have stock options outstanding with an exercise price of $90.00. For BCF’s next annual general meeting, management has included a motion to adjust the exercise price of these stock options to $80.00, since the rights issue for $80.00 per share has diluted the value of executive and board stock options. Considering BCF’s situation, explain whether or not shareholders should support this motion. Identify any implications for shareholders in the future. Continued… PEFN2#1  CGA-Canada Page 4 of 5 17 Question 4 Link This Corp. (LT) is an Internet service company. It offers advertising and Internet search solutions. The company started in 2006 with new search technology developed by its founders to retrieve relevant information from a large set of data. The $1 million initial investment was contributed by the founders and their families and some friends (internal equity investors). The Internet search technology was a big success and the company quickly outgrew the financial constraints of a private business. In 2010, LT, in its initial public offering (IPO) of ordinary shares to the general public (external equity investors), raised $2 billion. LT is improving its search technology, developing new related technologies, and exploring and expanding into other online businesses. Its growth rate is still very high and is expected to be high for many years to come. Required 2 a. Briefly explain which type of financing (debt or equity) would be the usual form of financing for a company at LT’s stage of growth. 2 b. State one advantage and one disadvantage of having external equity investors as shareholders of LT. 4 c. State the two methods of issuing ordinary equity to external equity investors. Contrast these two methods with at least one advantage for each method. 2 d. State which type of cash dividend policy (zero, low, or high) is the most appropriate for LT to follow and why. 3 e. Briefly explain the three alternative applied cash dividend policies. 4 f. Recommend a cash dividend policy for LT. Explain your reasoning for the policy by mentioning at least three factors. 15 Question 5 Golden Mining Co. (GM) is a gold producer based in Canada. Gold is priced and sold in U.S. dollars on both domestic and international markets. The price of gold has been rising and many experts believe that the price has reached its peak level, but feel that the price may drop soon. GM operates mainly within Canada and incurs most expenses in Canadian dollars. Similar to the price of gold, the Canadian dollar has also been rising. Many experts warn that an adjustment may begin soon, but there is no immediate sign that the Canadian dollar will weaken against the U.S. dollar. Required Provide an analysis to advise GM management on the following issues: 2 a. State two types of treasury risk facing GM. 3 b. Identify the three main hedging alternatives available to GM. 10 c. Explain how to use each of the three hedging alternatives you identified in part (b) to hedge against each type of risk you identified in part (a). Specify the position (buy or sell), describe how each alternative works under two different scenarios, and compare the three alternatives wherever appropriate. Continued… PEFN2#1  CGA-Canada Page 5 of 5 20 Question 6 White Paper Co. (WP) is a Quebec-based manufacturer of paper products. It is considering a $20 million project. The project will last 10 years, and the $20 million asset with a CCA rate of 20% is expected to be worthless at the end of the project. Annual incremental operating revenue from the project is estimated to be $10 million, and annual incremental operating costs will be $6 million. WP has a corporate tax rate of 50%. The industry average tax rate is 40%. The company has a debt ratio of 40%, which is lower than the industry average of 50%. The industry average beta is 1.20. The risk-free rate is 4% and the market risk premium is 8%. WP has decided to finance this project with 40% debt and 60% equity. The flotation costs associated with equity financing is 3%. WP is able to borrow on the market at a before-tax interest rate of 7%. Since the industry has been negatively affected by rising energy, fuel, and road-building costs, as well as a higher Canadian dollar, both the federal and provincial governments have provided financial aid to the industry. WP qualifies for operating cost subsidies provided by the provincial government and a low- interest loan offered by the federal government. The operating cost subsidies amount to $1 million (before tax) at the end of each year for the first three years. WP has decided to use the low-interest loan to finance the debt portion of the project. The loan carries a before-tax interest rate of 3% and is a bullet loan for 10 years with the principal due at the end of the loan term. Required 2 a. Indicate why the adjusted present value (APV) method is the most appropriate method for evaluating this project. 2 b. Indicated what discount rate should be used to calculate the net present value (NPV) of the base-case. Calculate this discount rate. 4 c. With no financial aid from the governments and assuming WP finances the project out of equity cash flows from retained earnings, indicate whether WP should accept the project. Support your answer with calculations for the base-case NPV. 12 d. With financial aid from the governments and additional equity financing, indicate whether WP should accept the project. Support your answer with calculations for the adjusted present value. END OF EXAMINATION 100 FN2 CGA-Canada Attachment 1 of 26 Advanced Corporate Finance [FN2] Formulas ( ) Present value of a future value (FV) amount n = number of periods i = rate per period ( ) Future value of a present value (PV) amount [ ( ) ] Present value of an ordinary annuity PMT = periodic payment [ ( ) ] Future value of an ordinary annuity PMT = periodic payment ( ) Present value of an asset discounted at the lending and borrowing rate C0 = current cash flow CF1 = cash flow expected next period r = market lending/borrowing rate ∑ ( ) Expected value (mean) of random variable x ∑( ) ( ) ( ) ( ) ∑ ( ) Population variance of random variable x ∑∑( )( ) ( ) Population covariance of two random variables x and y Coefficient of correlation (population) FN2 CGA-Canada Attachment 2 of 26 ̅ Mean of historical returns ( ̅) ( ̅) ( ̅) ∑( ̅) Variance of returns where each outcome has an equal probability (population) ( ̅) ( ̅) ( ̅) ∑( ̅) Variance of returns where each outcome has an equal probability (sample) ∑ Return of a portfolio based on the weighted average of the asset returns n = number of securities in the portfolio wi = weight of return i, calculated as the ratio of the amount invested in security i divided by the total investment Ri = return on security i ( ) ∑ Expected return of a portfolio using probable outcomes n = number of possible outcomes Pi = probability of outcome i RPi = portfolio return associated with outcome i ∑ [ ( )] Variance of a portfolio (population) ( ) ∑ ( ) Expected return on a portfolio using a weighted average of expected returns of its investments wi = weight of investment i in the portfolio n = number of investments in the portfolio FN2 CGA-Canada Attachment 3 of 26 Variance of a two-investment portfolio 1 = standard deviation of investment 1 2 = standard deviation of investment 2 12 = correlation coefficient of investments 1 and 2 ∑∑ Variance of an n-investment portfolio ij = correlation coefficient between securities i and j ( ) ( ) ( ) Expected return on a portfolio containing a risk-free asset and the market portfolio Rf = risk-free rate wi = portion invested in the risk- free asset E(RM) = expected return on the market portfol