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QUESTION ONE Financial Management/Cashflow Analysis (10 marks)

1. In Finance, the focus is more on the wealth maximization of the shareholder, though profit maximization is considered a part of the wealth maximization objective. Discuss. (4 Marks)
2. Define “the stand-alone principle” applied in evaluating projects and discuss the types of cashflows in project evolution. (6 Marks)

QUESTION TWO Financial Mathematics (10 marks)

1. Calculate the present value of a four-period annuity of $200 per year that begins two years from today if the discount rate is 9%? (2 Marks)

• Your favourite Grandma is so proud that you have decided to obtain a degree in such a useful discipline as Finance that she is willing to assist you with your course-related and living costs. Even though she is old and frail she is a whiz with her personal finances and to help you out she has offered you a choice between an outright gift of $20,000 or

$100,000 interest-free loan to be paid back in five equal annual instalments of $20,000 each. Demonstrate making use of financial mathematics which alternative represents the optimal choice? Hint: You should find the interest rate of indifference first and then make an informed decision. (6 Marks)

• How many monthly payments remain to be paid on an 8% mortgage with a 30-year amortisation and monthly payments of $733.76, when the balance reaches one-half of the initial $100,000 amount borrowed? (2 Marks)

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QUESTION THREE Share & Bond Valuation (15 marks)

1. The Camry Robbins Corporation has two different bonds currently outstanding. Bond A has a face value of $40,000 and matures in 20 years. The bond makes no payments for the first six years and then pays $2,000 semi-annually for the subsequent eight years, and finally pays $2,500 semi-annually for the last six years. Bond B also has a face value of $40,000 and a maturity of 20 years; it makes no coupon payments over the life of the bond. If the required rate of return is 12 per cent compounded semi-annually, what is the current price of bond A? or Bond B? (5 Marks)

• Warne Unlimited 5-year bonds are currently trading at $768 per $1,000 of face value. If these bonds pay interest semi-annually and the market requires that they offer a 10% annual rate of return, what annual coupon rate is being offered? (5 Marks)

• Trusty gets’ Lucky Ltd., just paid a dividend of $2.00 per share. The managing director just announced that it is planned to increase dividends at a rate of 6% indefinitely. An appropriate discount rate for this company is 16% per annum. (5 Marks)

1. What is the firm’s expected dividend stream over the next 3 years?
2. What is the firm’s current stock price?
3. What is the firm’s expected value in one year?
4. What are the expected dividend yield, capital gains yield and total return during the first year?

QUESTION FOUR Capital Budgeting (10 marks)

Mr Burns the President of the Springvale Electrical Company is sick and tired of falling cash flows and as a result, decreasing NPV. The company itself is responsible for making electrical components, but of late has been suffering from decreasing output as the result of one particularly lazy employee. The financial director, Mr Burns’ son, George, has come up with an idea of how to overcome this problem.

“It’s easy, the guy sits around all day stuffing his face with food and sleeping, it’s no wonder output has fallen substantially. All we have to do to get things rolling again is to replace him with a new fully automated machine.”

This replacement would mean the need for one less employee to generate salary and benefit savings. The following day the director carries out a feasibility study and the following data is presented to the President.

• It would cost $60,000 to purchase the new automated machine and it would be expected to have a life expectancy of 20 years.
• Annual maintenance would be $8,000.
• The replaced employee’s salary is $25,500.
• The machine will be depreciated on a straight-line basis over 20 years to a zero salvage value.
• The firm’s marginal tax rate is 30 per cent.
• The firm’s current cost of capital is estimated to be 15%.

Based on the net present value criterion, should the automated machine be purchased and the lazy operator fired? Confirm that your answer is correct by calculating the Internal Rate of Return. Does your answer make sense? Comment

QUESTION FIVE Risk and Return (5 marks)

You believe that there is a 40 per cent chance that stock A will decline by 10 per cent and a 60 per cent chance that it will rise by 20 per cent. Correspondingly, there is a 30 per cent chance that stock B will decline by 10 per cent and a 70 per cent chance that it will rise by 20 per cent. The correlation coefficient between the two stocks is 0.70. Calculate the expected return, the variance, and the standard deviation for each stock. Then calculate the covariance between their returns.

QUESTION SIX Diversification (10 marks)

1. Should small or high-growth firms have higher betas than larger and more mature firms? Discuss. (5 Marks)

• Due to the distinctive nature of unsystematic risk, it can be reduced or eliminated through diversification. Do you agree with this statement? Explain. (5 Marks)

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