Question 2 [Part I and IIare separate  20 marks]: Part II


 Marylou Moore
 1 years ago
 Views:
Transcription
1 Question 1 [20 marks, maximum one page single space] : a. Explain the di erence between a marketvalue balance sheet and a bookvalue balance sheet. b. What is meant by overthecounter trading? c. Distinguish between a rm s capital budgeting decision and nancing decision. d. Based on the dividend growth model, what are the twocomponents of the totalreturn on ashare of a stock? Which do you think is typically larger? Also, in the context of the dividend growth model, is it true that the growth rate in dividends and the growth rate in the price of the stock are identical? Question 2 [ and IIare separate  20 marks]: The rm of Beryl Agatha had sales of $20,000 in The cost of goods sold was $13,000, general and administrative expenses were $2,000, interest expenses were $1,000, and depreciation was $2,000. Working capital increased $400 and capital expenditures were $1,800. The rm s tax rate is 35 percent. a. What are the rm s earnings before interest and taxes? b. What is the rm s net income? c. What is the rm s cash ow from operating activities? Determine the net income and also the cash ow from operations for the following rm: $500,000 sales, $10,000 cash dividends, $300,000 cost of goods sold, $20,000 administrative expense, $20,000 depreciation expense, $40,000 interest expense, and a tax rate of 34 percent. Question 3 [20 marks]: Your landscaping company can lease a truck for $8, 000 a year (paid at yearend) for 6 years. It can buy the truck for $40, 000. The truck will be valueless after six years. a. If the interest rate your company can earn on its funds is 7 percent, is it cheaper to buy or lease? b. If the lease payments are an annuity due, is it cheaper to buy or lease? On a recent trip south, you win the super jackpot in the Florida state lottery, with a payo of $4,960,000. On reading the ne print, you discover that you have the following two options: a. You receive $160,000 at the beginning of each year for 31 years. The income would be taxed at an average rate of 28%. Taxes are withheld when cheques are issued. b. You receive $1,750,000now, but you do not have access to the full amount immediately. The $1,750,000 would be taxed at an average rate of 28%. You are able to take $446,000 of the aftertax amount now. The remaining $814,000 will be placed in a 30year annuity account that pays $101,055 on a beforetax basis at the end of each year. Using a discount rate of 6%, which option should you select? Question 4 [20 marks]: Are the following statements true or false? Provide simple examples to support your assessment. a. If interest rates rise, bond prices rise. b. If the bond s yield to maturity is greater than its coupon rate, the price is greater than the bond s face value. c. High coupon bonds of a given maturity sell for lower prices than the otherwise identical lowcoupon bonds. d. If interest rates change, the price of a highcoupon bond changes proportionately more than the price of a lowcoupon bond of the same maturity and default risk. e. An investor who owns a 10%, 5year Canada bond is wealthier if interest rates rise from 4% to 5%. Question 5 [ and IIare separate, 20 marks]: The just paid dividend this year on a share of common stock is $10. Assuming dividends grow at a 5% rate for the foreseeable future, and that the required rate of return is 10%, what is the value of the share today? Last year? Next Year? 1
2 Tattletale News Corp. has been growing at a rate of 20 percent per year, and you expect this growth rate in earnings and dividends to continue for another 3 years. a. If the just paid dividend were $2, what will the next dividend be? b. If the discount rate is 15 percent and the steady growth rate after 3 years is 4 percent, what should the stock price be today? c. What is your prediction for the stock price in one year? d. Show that the expected rate of returns equals the discount rate? Note: PVIFA (r;t) = [1 1=(1 + r) t ]=r FVIFA (r;t) = [(1+ r) t 1]=r YTM = [C i + (P p P m )=n]=[(p p + P m )=2] where C i is the coupon; P p the par value; P m the current market value; and n is the maturity. PVIF (r;t) = [1=(1 + r) t ] FVIF (r;t) = [(1+ r) t 2
3 Solutions for the Midterm Solution 1: a. For some assets, depreciation expense is an accurate portrayal of reduction in market value. However, it is not at all uncommon for market value to be distinctly di erent from depreciated book value. This can be especially true for land, which is not depreciated but has often appreciated if it has been on the books for a long period of time. In a similar manner, liabilities may have a di erent market value if market interest rates on similar liabilities have changed su ciently since the liability was issued. Finally, investors and analysts may have critical information about the future prospects for the rm that has not been incorporated into current generally accepted accounting principles. b. Overthecounter refers to trading that does not take place on a centralized exchange such as the New York Stock Exchange. Trading of securities on NASDAQ is overthecounter, because NASDAQ is a network of security dealers linked by computers. Although some corporate bonds are traded on the New York Stock Exchange, most corporate bonds are traded overthecounter, as are all U.S. Treasury securities. Foreign exchange trading is also overthecounter. c. Examples of the capital budgeting decision for a rm could include: a decision to replace all of the rm s personal computers, a decision to expand the size of the production facility, a decision to buy a corporate jet, a decision to expand production into two new product lines, et cetera. Examples of the nancing decision for a rm could include: a decision to issue corporate bonds rather than expand a bank loan, a decision to oat a new issue of common stock, a decision to denominate a loan in Japanese yen rather than Canadian dollars, a decision to roll over shortterm nancing rather than borrow for a longer term, et cetera. d. The two components are the dividend yield and the capital gains yield. For most companies, the capital gains yield is larger. This is easy to see for companies that pay no dividends. For companies that pay dividends, the dividend yields are rarely over ve percent and are often much less. Yes, if the dividend grows at a steady rate, so does the stock price. In other words, the dividend growth rate and the capital gains yield are the same. Solution 2: a) What are the rm s earnings before interest and taxes? Sales $10,000 Cost of goods sold 6,500 G & A expenses 1,000 Depreciation expense 1,000 EBIT 1,500 b) What is the rm s net income? EBIT 1,500 Interest expense 500 Taxable income 1,000 (35%) 350 Net income $ 650 c) What is the rm s cash ow from operating activities? Ans: Cash ow from operations = net income + depreciation expense 650+1,000 = $1,650 Sales $500,000 Cost of Goods Sold 300,000 Administrative Expense 20,000 Depreciation Expense 20,000 EBIT 160,000 Interest Expense 20,000 Income Taxes 47,600 Net Income $ 92,400 Adding depreciation expense to net income provides a cash ow from operations of $112,400. Solution 3: 3
4 a. Compare the present value of the lease to cost of buying the truck. Present Value of lease = 8;000 P VIF A(7%;6) = $38;132:32: It is cheaper to lease than buy because by leasing the truck will cost only $38,132.32, rather than $40,000. Of course, the crucial assumption here is that the truck is worthless after 6 years. If you buy the truck, you can still operate it after 6 years. If you lease it, you must return the truck and replace it. b. If the lease payments are payable at the start of each year, then the present value of the lease payments are: PV annuity due lease = 8; ;000 PV IFA(7%;5) = 8; ;801:58 = $40;801:58: Note too that PV of an annuity due = PV of ordinary annuity (1 + r). Therefore, with immediate payment, the value of the lease payments increases from its value in the previous problem to $38;132 1:07 = $40;801 which is greater than $40,000 (the cost of buying a truck). Therefore, if the rst payment on the lease is due immediately, it is cheaper to buy the truck than to lease it. Option one: this cash ow is an annuity due. To value it, you must use the aftertax amounts. The aftertax payment is $160,000 (10.28)=$115,200. Value all except the rst payment using the standard annuity formula, then add back the rst payment of $115,200 to obtain the value of this option. Value = $115,200 + $115,200 [PVIFA(30,0.06)] Value = $115,200 + $115,200 ( )=$1,700, Option two: this option is valued similarly. You are able to have $446,000 now; this is already on an aftertax basis. You will receive an annuity of $101,055 for each of the next thirty years. Those payments are taxable when you receive them, so your aftertax payment is $72, [=$101,055(10.28)]. Value = $446,000 + $72, [PVIFA(30,0.06)] Value = $ 446,000 + $72, ( ) =$1,447, Since option one has a higher present value, you choose it. Solution 4: a. False. Since a bond s coupon payments and principal are xed, as interest rates rise, the present value of the bond s future cash ow falls. Hence, the bond price falls. Example: Twoyear bond 3% coupon, paid annual. Current YTM = 6% Price = 30 annuityfactor(6%;2) =(1 + :06)2 = 945 If rate rises to 7%, the new price is: Price = 30 annuityfactor(7%;2) =(1 + :07)2 = 927:68 b. False. If the bond s YMT is greater than its coupon rate, the bond must sell at a discount to make up for the lower coupon rate. For an example, see the bond in a. In both cases, the bond s coupon rate of 3% is less than its YTM and the bond sells for less than its $1,000 par value. c. False. With a higher coupon rate, everything else equal, the bond pays more future cash ow and will sell for a higher price. Consider a bond identical to the one in a. but with a 6% coupon rate. With the YTM equal to 6%, the bond will sell for par value, $1,000. This is greater the $945 price of the otherwise identical bond with a 3% coupon rate. d. False. Compare the 3% coupon bond in a with the 6% coupon bond in c. When YTM rises from 6% to 7%, the 3% coupon bond s price falls from $945 to $927.68, a % decrease (= ( )/945). The otherwise identical 6% bonds price falls to 981:92(= 60 annuityfactor(7%;2)+ 1000=(1+ :07)2) when the YTM increases to 7%. This is a % decrease (= 981: =1000), which is slightly smaller. The prices of bonds with lower coupon rates are more sensitivity to changes in interest rates than bonds with higher coupon rates. e. False. As interest rates rise, the value of bonds fall. A 10 percent, 5 year Canada bond pays $50 of interest semiannually (= :10=2 $1;000): If the interest rate is assumed to be compounded semiannually, the per period rate of 2% (= 4%/2) rises to 2.5% (=5%/2). The bond price changes from: Price = 50 *annuity factor (2%;2 5) =(1 + :02)10 = $1;269:48 to: Price = 50 *annuity factor(2:5%;2 5) =(1+ :025)10 = $1;218:80 The wealth of the investor falls 4%(= $1;218:80 $1;269:48=$1;269:48). Question 5: 1) The value today (P 0 ) is: 4
5 P 0 = D 1 =(r g) = $10(1:05)=(:10 :05) = $210: The value last year (P 1 ) = D 0 =(r g) = $10=(:10 :05) = $200 The value of the stock next year (P 1 ) = D 2 =(r g) = (D 1 (1 + g))=(r g) = D 0 (1+ g) 2 =(r g) = $10(1.05) 2 =(:10 :05) = $220:50 Notice that the price increases at the same growth rate that the dividends increase; that is : P 1 (1+ g) = $200 1:05 = $210 = P 0 P 0 (1 + g) = $210 1:05 = $220:50 =P 1 2) 31. a. DIV1 = $2*1.20 = $2.40 b. DIV1 = $2.40; DIV2 = $2.88, DIV3 = $3.456 P3 = * 1.04/( ) = $ P0 = 2.40/ / ( )/ = $28.02 c. P1 = 2.88/ ( )/ = $ d. d. Capital gain = P1  P0 = $ $28.02 = r = ( )/28.02 =.15 = 15% 5
Lesson 1. Net Present Value. Prof. Beatriz de Blas
Lesson 1. Net Present Value Prof. Beatriz de Blas April 2006 1. Net Present Value 1 1. Introduction When deciding to invest or not, a rm or an individual has to decide what to do with the money today.
More informationLOS 42.a: Define and interpret free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).
The following is a review of the Equity Investments principles designed to address the learning outcome statements set forth by CFA Institute. This topic is also covered in: Free Cash Flow Valuation This
More informationTHE TIME VALUE OF MONEY
1 THE TIME VALUE OF MONEY A dollar today is worth more than a dollar in the future, because we can invest the dollar elsewhere and earn a return on it. Most people can grasp this argument without the use
More informationMIT Sloan Finance Problems and Solutions Collection Finance Theory I Part 1
MIT Sloan Finance Problems and Solutions Collection Finance Theory I Part 1 Andrew W. Lo and Jiang Wang Fall 2008 (For Course Use Only. All Rights Reserved.) Acknowledgements The problems in this collection
More informationSolutions Manual. Corporate Finance. Ross, Westerfield, and Jaffe 9 th edition
Solutions Manual Corporate Finance Ross, Westerfield, and Jaffe 9 th edition 1 CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE Answers to Concept Questions 1. In the corporate form of ownership, the shareholders
More informationMBA Financial Management and Markets Exam 1 Spring 2009
MBA Financial Management and Markets Exam 1 Spring 2009 The following questions are designed to test your knowledge of the fundamental concepts of financial management structure [chapter 1], financial
More informationCHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA
CHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Answers to Concepts Review and Critical Thinking Questions 1. Assuming conventional cash flows, a payback period less than the project s life means
More information10. Time Value of Money 2: Inflation, Real Returns, Annuities, and Amortized Loans
10. Time Value of Money 2: Inflation, Real Returns, Annuities, and Amortized Loans Introduction This chapter continues the discussion on the time value of money. In this chapter, you will learn how inflation
More informationBUYER S GUIDE TO FIXED DEFERRED ANNUITIES. The face page of the Fixed Deferred Annuity Buyer s Guide shall read as follows:
BUYER S GUIDE TO FIXED DEFERRED ANNUITIES The face page of the Fixed Deferred Annuity Buyer s Guide shall read as follows: Prepared by the National Association of Insurance Commissioners The National Association
More informationH O W T O C A L C U L A T E PRESENT VALUES CHAPTER THREE. Brealey Meyers: Principles of Corporate Finance, Seventh Edition
CHAPTER THREE H O W T O C A L C U L A T E PRESENT VALUES 32 IN CHAPTER 2 we learned how to work out the value of an asset that produces cash exactly one year from now. But we did not explain how to value
More informationWith any annuity, there are two distinct time periods involved: the accumulation period and the payout or annuity period:
A n annuity is simply a stream of periodic payments. Start with a lump sum of money, pay it out in equal installments over a period of time until the original fund is exhausted, and you have created an
More informationChapter 21 The Statement of Cash Flows Revisited
Chapter 21 The Statement of Cash Flows Revisited AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment. Although schools, departments,
More informationfor Analysing Listed Private Equity Companies
8 Steps for Analysing Listed Private Equity Companies Important Notice This document is for information only and does not constitute a recommendation or solicitation to subscribe or purchase any products.
More informationCIMA F3 Course Notes. Chapter 3. Short term finance
CIMA F3 Course Notes c Chapter 3 Short term finance Personal use only  not licensed for use on courses 31 1. Conservative, Aggressive and Matching strategies There are three overriding approaches to
More informationST334 ACTUARIAL METHODS
ST334 ACTUARIAL METHODS version 214/3 These notes are for ST334 Actuarial Methods. The course covers Actuarial CT1 and some related financial topics. Actuarial CT1 which is called Financial Mathematics
More informationWhat do Canadian Imperial Bank of Commerce,
CHAPTER 7 Interest Rates and Bond Valuation What do Canadian Imperial Bank of Commerce, Domtar, Loblaw, Husky Energy, and Rogers Communications all have in common? Like many other corporations they have
More informationUnderstanding Annuities
Understanding Annuities Annuities issued by Pruco Life Insurance Company (in New York, issued by Pruco Life Insurance Company of New Jersey) and The Prudential Insurance Company of America. 01609940000600
More informationPresent Value. Aswath Damodaran. Aswath Damodaran 1
Present Value Aswath Damodaran Aswath Damodaran 1 Intuition Behind Present Value There are three reasons why a dollar tomorrow is worth less than a dollar today Individuals prefer present consumption to
More informationINSURED ANNUITY STRATEGY. Help your clients increase their aftertax income with universal life, without reducing the estate for their heirs.
INSURED ANNUITY STRATEGY Help your clients increase their aftertax income with universal life, without reducing the estate for their heirs. Here s the story Dennis and Rosemary, ages 68 and 64, have worked
More informationPaper P4. Advanced Financial Management. Professional Pilot Paper Options module. The Association of Chartered Certified Accountants
Professional Pilot Paper Options module Advanced Financial Management Time allowed Reading and planning: Writing: 15 minutes 3 hours This paper is divided into two sections: Section A THIS ONE question
More informationCHAPTER 6. Accounting and the Time Value of Money. 2. Use of tables. 13, 14 8 1. a. Unknown future amount. 7, 19 1, 5, 13 2, 4, 6, 7, 11
CHAPTER 6 Accounting and the Time Value of Money ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics Questions Brief Exercises Exercises Problems 1. Present value concepts. 1, 2, 3, 4, 5, 9, 17 2. Use of
More informationUnderstanding Annuities: A Lesson in Indexed Annuities
Understanding Annuities: A Lesson in Indexed Annuities Did you know that an annuity can be used to systematically accumulate money for retirement purposes, as well as to guarantee a retirement income that
More information1. Define the operating and cash cycles. Why are they important?
ShortTerm Planning Learning Objectives 1. Define the operating and cash cycles. Why are they important? 2. Define the different types of shortterm financial policy 3. Understand the essentials of shortterm
More information5 More on Annuities and Loans
5 More on Annuities and Loans 5.1 Introduction This section introduces Annuities. Much of the mathematics of annuities is similar to that of loans. Indeed, we will see that a loan and an annuity are just
More informationH O W T O R E A D A FINANCIAL REPORT
H O W T O R E A D A FINANCIAL REPORT HOW TO READ A FINANCIAL REPORT GOALS OF THIS BOOKLET An annual report is unfamiliar terrain to many people. For those who are not accountants, analysts or financial
More informationConsumer s Guide to. Fixed Deferred Annuities
Consumer s Guide to Fixed Deferred Annuities Louisiana Department of Insurance Jim Donelon, Commissioner CONTENTS What is an Annuity?...3 What are the different kinds of Annuities?...4 How are the interest
More informationChapter 3 Present Value
Chapter 3 Present Value MULTIPLE CHOICE 1. Which of the following cannot be calculated? a. Present value of an annuity. b. Future value of an annuity. c. Present value of a perpetuity. d. Future value
More informationIntegrated Case. 542 First National Bank Time Value of Money Analysis
Integrated Case 542 First National Bank Time Value of Money Analysis You have applied for a job with a local bank. As part of its evaluation process, you must take an examination on time value of money
More informationLife Insurance Companies and Products
Part B. Life Insurance Companies and Products The current Federal income tax treatment of life insurance companies and their products al.lows investors in such products to obtain a substantially higher
More informationAnnuity Answer Booklet
Annuity Answer Booklet Explanations of Annuity Concepts and Language Standard Insurance Company Annuity Answer Booklet Explanations of Annuity Concepts and Language Annuity Definition... 3 Interest Rates...
More information