# Education In Pakistan

## VU FIN622- Corporate Finance (Session – 3) MIDTERM EXAMINATION Spring 2010

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MIDTERM EXAMINATION

Spring 2010

FIN622- Corporate Finance (Session – 3)

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

Which of the following is a transaction of a primary financial market?

Initial Public Offering –

The methods by which the primary market transactions carried out are –

► Selling old shares

► Buying Bonds issued in previous years

Question No: 2 – – Please choose one

Last year ABC Company had a 9.00% net profit margin based on Rs.22,000,000

in sales and Rs.15,000,000 of total assets. During the coming year, the president

has set a goal of attaining a 14% return on total assets. How much must firm

sales equal, other things being the same, for the goal to be achieved?

Rs.23,333,333 –

Net income =22000000*9%= 1980000

Return on total assets = net income / total assets

= 1980000/15000000

= 0.132

= 23333333/1500000 = 1.4

= 15000000*0.14 = 2100000

= 2100000*100/9

Sales = 23,333,333

► Rs.22,000,000

► Rs.26,722,967

► Rs.25,603,667

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

If you want to earn 8 percent, approximately how much should you pay for a

security which matures in one year at Rs. 1,000?

► Rs. 1,080

► Rs. 940

► Rs. 920

Rs. 926 –

Fv= pv (1+i) ^n

1000 = (1+0.08) ^1

PV = 1000/ 1.08

= 925.9 = 926

Question No: 4 – – Please choose one

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Which of the following statements describes the term structure of interest rates?

► Term structure of interest rates refers to the relationship between yield and

rating, for securities with the same maturity.

► Term structure of interest rates refers to the relationship between yield and

marketability, for securities with the same tax status.

Term structure of interest rates refers to the relationship between yield

and maturity, for the same security class. –

http://www.pimco.com/LeftNav/Bond+Basics/2006/Yield_Curve_Basics.htm

A yield curve depicts yield differences, or yield spreads, that are due solely

to differences in maturity. It therefore conveys the overall relationship that

prevails at a given time in the marketplace between bond interest rates and

maturities. This relationship between yields and maturities is known as the

term structure of interest rates.

► Term structure of interest rates refers to the relationship between yield and

risk, for securities with the same maturity.

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

A Company’s common stock is currently selling at Rs.3.00 per share, its quarterly

dividend is Rs.0.07, and the stock is expected to rise to Rs.3.30 in a year. What

is its expected rate of return?

► 9.3%

19.3% –

3.30 – 3.00 = 0.30

0.07 * 4 = 0.28 + 0.30 = 0.58

58 / 3 = 0.1933 * 100 = 19.33%

► 10.0%

► 11.0%

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

For a firm with a Degree of Operating Leverage of 3.5, an increase in sales of 6%

will:

► Increase pre-tax profits by 3.5%

► Decrease pre-tax profits by 3.5%.

Increase pre-tax profits by 21.0%. –

6 * 3.5 = 21%

► Increase pre-tax profits by 1.71%.

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

Which of the following best illustrates the problem imposed by capital rationing?

► Accepting projects with the highest NPVs first

► Accepting projects with the highest IRRs first

By passing projects that have positive NPVs –

► By passing projects that have positive IRRs

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

Which of the following is determined by variance of an investment’s returns?

► Volatility of the rates of return.

► Probability of a negative return.

► Historic return over long periods.

Average value of the investment. –

Page 48

The variance essentially measures the average squared difference between the

actual returns and the average return.

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

Which of the following conditions, if exist, will make the diversification of stocks

more effective?

► Securities contained in a portfolio are positively correlated

Securities contained in a portfolio are negatively correlated –

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Page 50

Diversification

An investor can reduce portfolio risk simply by holding instruments which are not

perfectly correlated.

► Securities contained in a portfolio have high market values

► Securities contained in a portfolio have low market values

Question No: 10 – – Please choose one

Suppose a stock is selling today for Rs.35 per share. At the end of the year, it

pays a dividend of Rs.2.00 per share and sells for Rs.39.00. What is the dividend

yield on this stock?

► 2%

► 3%

► 4%

5% –

Dividend yield = Annual dividends per share / price per share

= 2 / 35 = 0.057 = 5%

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

Which of the following statements applies to Security Market Line (SML)?

► Security Market Line (SML) shows the relationship between expected rate of

return and required rate of return of a security.

► Security Market Line (SML) shows the relationship between Beta and market

value of a security.

Security Market Line (SML) shows the relationship between required rate

of return and beta coefficient of a security. –

Page 52 Securities Market Line

The relationship between Beta & required return is plotted on the securities

market line (SML) which shows expected return as a function of β. The intercept

is the risk-free rate available for the market,

► Security Market Line (SML) shows the relationship between Market value and

face value of a security.

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

Which of the following is known as market portfolio?

► A portfolio consists of all risk free securities available in the market

► A portfolio consists of securities of the same industry

► A portfolio consists of all aggressive securities available in the market

A portfolio consists of all securities available in the market –

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

A firm had an interest expense of Rs.400,000 on its outstanding debt during the

financial year 2006-2007. If the firm marginal tax rate is 40%, what was the total

tax savings of the firm during the period 2006-2007?

► Rs.150, 000

Rs.160, 000 –

400,000 *40% = 160,000

► Rs.170, 000

► Rs.180, 000

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

A Pure Play method of selecting a discount rate is most suitable in which of the

following situations?

► When the intended investment project has a Non-conventional stream of cash

flows

► When the intended investment project is a replacement project

When the intended investment project belongs to industry other than the

firms operating in –

► When the intended investment project has a conventional stream of cash

flows

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

Which of the following statements is TRUE regarding an Un-levered firm?

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► Its Return on Equity is equal to Return on Assets

Its Return on Equity is equal to Return on Investment –

► Its Return on Equity is equal to Return on Sales

► Its Return on Equity is equal to Return on Non-fixed Assets

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

Which of the following is the principal advantage of high debt financing?

Tax savings –

► Low Bankruptcy costs

► Minimum financial risk

► Low financial leverage

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

Which of the following is the main objective of a Residual Dividend Policy?

To use internal resources for investment in projects and business

operations –

► To pay a fixed amount of Dividend to shareholders of the firm

► To maintain a constant payout ratio

► To stabilize Dividend per share

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

Which of the following methods would be most suitable for calculating the return

on stocks of a non-listed company?

Dividend Growth Model –

► Capital Asset Pricing Model

► Security Market Line

► Characteristics Line

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

What will be the effect of reduction in the cost of capital on the accounting breakeven

level of revenues?

► It raises the break-even level.

► It reduces the break-even level.

It has no effect on the break-even level. –

► This cannot be determined without knowing the length of the investment

horizon.

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

Which of the following are the primary sources of capital to the firm?

Net income, Retained earnings and Bank loans –

► Bonds, Preferred stock and Common stock

► Operating profits, extraordinary gains and Dividends

► Amortization cash flow, Net income and Retained earnings

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

Suppose you invested Rs. 8,000 in a savings account paying 5 percent interest a

year, compounded annually. How much amount your account will have at the

end the end of four years?

► Rs.10, 208

Rs.9, 728 –

By appling formula of future value

► Rs.10, 880

► Rs.9, 624

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

Which of the following refers to an analysis of financial statements where all

balance sheet or income statement figures for a base year equal 100.0 and

financial statement items for subsequent years are expressed as percentages of

the base year values?

Common-size analysis –

Page 6 Base Year Analysis: Common Size analysis is also known as Vertical

Analysis. Base year analysis is another tool of comparing performance and is

also known as Horizontal Analysis In this case, performance is compared over,

say, five years period. The earliest year or the first year is taken as base year

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and every line item in the balance sheet of base year is taken as 100%. In the

subsequent years amounts of every line item are expressed as %age of base

year amount.

► Ratio analysis

► Index analysis

► Technical analysis

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

Which of the following is more appropriate to use while comparing investment

alternatives with different compounding periods?

► Quoted Interest Rate

► Annual Percentage Rate

Effective Annual Interest Rate –

Page # 15

Effective Annual Rate – EAR

The Effective Annual Rate (EAR) is the interest rate that is annualized using

compound interest. The EAR is the annualized equivalent of interest with

shorter

compounding periods.

It can be calculated from the following formula:

EAR = (1 + i/n) n – 1

► Nominal Interest Rate

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

ABC Company will pay a dividend of Rs.2.40 per share at the end of this year. Its

dividend yield is 8%. At what price is the stock selling?

► 40

► 35

30 –

Selling price = 2.40 / 0.08 = 30

► 25

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

Which one of the following costs should be ignored while evaluating the financial

viability of a project?

► Initial cost

► Equipment cost

► Cost of capital

Sunk cost –

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

In which of the following situations a project is acceptable?

► When a project has conventional cash flows patterns

► When a project has a non-conventional cash flow pattern

► When a project has a discounted rate higher than the inflation rate

When a project has a positive net present value –

Question No: 27 – – Please choose one

Which of the following capital budgeting methods states the project return as a

percentage?

► Payback period

► Net present value

Internal Rate of Return –

Internal Rate of Return is always quoted in terms of percentage, which makes it

comparable to the other market interest rates or the inflation rate

► None of the given options

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

What is the Net Present Value (NPV) of a project that costs Rs.100, 000 and

returns Rs.45, 000 annually for three years if the opportunity cost of capital is

14%?

► Rs.16, 100.00

► Rs.35, 000.00

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Rs.3, 397.57 – Doubted

► Rs.4, 473.44

Question No: 29 (Marks: 3)

How stable dividend policy could increase the marketability of a firm’s shares?

Question No: 30 (Marks: 3)

Differentiate between the single period capital rationing and multi-period

capital rationing.

Single period capital rationing

It is a situation where the company has limited amounts of funds in one

investment period only. After that period, the company can access funds from

various sources, e.g. issuing shares, borrowing from banks or issuing bonds.

Multi-period capital rationing

It occurs where the company has limited amounts of funds for a longer duration

of time. The capital constraints extend beyond one investment period. If we

assume that it’s possible to undertake fractional projects then the problem can be

formulated using linear programming. If the projects are indivisible, however,

then integer programming should be used.

Question No: 31 (Marks: 5)

In the year ending January 2008, Wal-Mart paid out Rs.1,326 million as debt

interest. How much more tax would Wal-Mart have paid if the firm had been

entirely financed by equity? What would be the present value of Wal-Mart’s

interest tax shield if the company planned to keep its borrowing permanently at

the 2008 level? Assume an interest rate of 8% and a corporate tax rate of 35%.

Question No: 32 ( Marks: 5 )

Suppose you are a capital budgeting manager of a company. For current year

you have a total capital budget of Rs.6,000,000. Following are given the projects

available for investment:

A B C

Projects Initial

Investment(millions)

8 3 3

Annual Cash flows

millions)

3 1.5 1

Project Life

(years)

5 3 6

Discount Rates

10% 8% 12%

Requirement:-

Which project(s) should be selected for investment with in the given budget?

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Owner’s Capital account

Question No: 38 ( Marks: 1 ) – Please choose one

The users of a statement of cash flows are mostly interested in:

► Net cash flow from operating activities

► Net cash flow from investing activities

Net cash flow from financing activities

► Net cash flow from non-cash transactions

Question No: 39 ( Marks: 1 ) – Please choose one

Which of the following question is NOT addressed by cash flow statement?

► How much cash was generated by the company’s operations?

Why is such a profitable company able to pay only small dividends?

► How much was spent for the new plants and equipment?

► How profitable the company’s current assets are?

Question No: 40 ( Marks: 1 ) – Please choose one

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 Adjusting entries Revenue Expenses Net income

a Deprecation expense

Accumulated depreciation

Decrease Increase Decrease

b Interest expense

Accrued interest

Decrease Increase Decrease

c Accrued revenue

revenue

Increase Decrease Increase

d Salaries

Accrued salaries

Decrease Increase Decrease

e Prepaid insurance Increase Decrease Increase

Which of the following statements is CORRECT regarding depreciation methods?

► Accumulated depreciation represents a fund being accumulated fro the replacement of

assets

► The cost of a machine includes the cost of repairing damage to the machine during the

installation process

► A company may use different depreciation methods in its financial statements and its

income tax returns

The use of an accelerated depreciation method causes an asset to wear out more

quickly than does the straight line method

Question No: 41 ( Marks: 5 )

Security Service Company adjusts its accounts at the end of the month. On November 30,

adjusting entries are prepared to record:

a. Depreciation expense for November

b. Interest expense that has accrued during November

c. Revenue earned during November that has not yet been billed to customers

d. Salaries, payable to company employees that have accrued since the last pay day in

November

e. The portion of the company’s prepaid insurance that has expired during November

Adjusting Entries For The Month Ended Nov 30

Requirement:

Indicate the effect of each of these adjusting entries on the major elements of the

company’s income statements i.e. upon revenue, expenses, net income. Organize your

answer in the table given below and use the symbols I for increase, D for decrease, and

NE for no effect.

Adjusting entry Revenue Expenses Net income

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Insurance

Question No: 42 ( Marks: 5 )

Olympic Inc., had the following cash flows during the current year:

Cash received from customers Rs. 240,000

Proceeds from the sale of the plant assets 330,000

Cash paid to suppliers and employees 127,000

Cash paid for the purchase of investments 45,000

Cash paid for the purchase of treasury stock 36,000

Cash inflow

Proceeds from the sale of the plant assets

240,000

50,000

330,000

Less Cash outflow

————– 620,000

Cash paid to suppliers and employees

Cash paid for the purchase of investments

127,000

45,000

Cash paid for the purchase of treasury stock

Cash flow during the year

36,000 208,000

__________

412,000