FNCE2121_PEAK(3)

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Thompson Rivers University *

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2121

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Jan 9, 2024

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THOMPSON RIVERS UNIVERSITY, OPEN LEARNING ANSWER KEY PRACTICE EXAMINATION FNCE 2121 • FINANCIAL MANAGEMENT

FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 2 of 16 TRU Open Learning FNCE 2121: Practice Exam Below are eight long ‐ answer questions worth 100 marks overall. Provide the requested details and label your work. Question 1 (5 marks) Assume that you really want to own a Ferrari and are willing to wait. You think that in 18 years you can buy a used one for $300,000. You currently have $65,000 to invest. What annual rate of interest must you earn on your investment to have your $300,000? Solution Calculator: 18 n 65,000 ‐ PV 300,000 FV 0 PMT I/yr = 8.868% Formula: We can use either the FV or the PV formula. Both will give the same answer since they are the inverse of each other. We will use the FV formula, that is: FV = PV(1 + r)t Solving for r, we get: r = (FV / PV)1 / t – 1 r = ($300,000 / $65,000)1/18 – 1 = 8.87%

FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 3 of 16 TRU Open Learning Question 2 (10 marks) You want to buy a new BMW for $83,500, and the finance office at the dealership has quoted you a 6.5% APR loan for 60 months to buy the car. a. What will your monthly payments be? (5 marks) b. Assuming the APR is compounded monthly, what is the effective annual rate on this loan? (5 marks) Solution a. Calculator: 60 n 83,500 PV 0 FV .5416667 I/yr pmt = 1,633.77 6.5 / 12 = .5416667 per month b. 12 n .5416667 I/yr 1 PV 0 pmt FV = 1.06697 less 1 = .06697 = 6.7% Formula: PVA = C({1 – [1/(1 + r)t ] } / r) $83,500 = $C[{1 – {1 / [1 + (0.065/12)]60} / (0.065/12)] $83,500 = $C *51.109 Solving for the payment, we get:

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FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 4 of 16 TRU Open Learning C = $83,500 / 51.109 = $1,633.76 To find the EAR, we use the EAR equation: EAR = [1 + (APR / m)]m – 1 EAR = [1 + (0.065 / 12)]12 – 1 = 0.0670 or 6.67% Question 3 (10 marks) Lucky Strike Corp. has outstanding bonds making annual payments, with 9 years to maturity, and selling for $948. At this price, the bonds yield 5.9%. a. What is the coupon rate on a $1,000 face value bond? (5 marks) b. Explain why some bonds sell at a premium over par value while other bonds sell at a discount. (5 marks) Solution a. Calculator: 9 n 5.9 I/yr 948 ‐ PV 1,000 FV pmt = 51.39 51.39/1000 = 5.139% Formula: Here, we need to find the coupon rate of the bond. All we need to do is to set up the bond pricing equation and solve for the coupon payment as follows: P = $948 = C(PVIFA5.9%,9) + $1,000(PVIF5.9%,9)

FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 5 of 16 TRU Open Learning Solving for the coupon payment, we get: C = $51.39 The coupon payment is the coupon rate times par value. Using this relationship, we get: Coupon rate = $51.39 / $1,000 = 0.05139 or 5.139% b. If the coupon rate is higher than the required return on a bond, the bond will sell at a premium, since it provides periodic income in the form of coupon payments in excess of that required by investors on other similar bonds. If the coupon rate is lower than the required return on a bond, the bond will sell at a discount since it provides insufficient coupon payments compared to that required by investors on other similar bonds. Question 4 (10 marks) Yukon Healthcare Corp. is a start ‐ up company. No dividends will be paid on the stock over the next 9 years because the firm needs to reinvest profits for growth. The company will pay a $12 ‐ per ‐ share dividend in 10 years and will increase the dividend by 5% per year thereafter. If the required return on this stock is 13.5%, what is the current share price? Solution Here we have a stock that pays no dividends for 10 years. Once the stock begins paying dividends, it will have a constant growth rate of dividends. We can use the constant growth model at that point. It is important to remember that general constant dividend growth formula is: Pt = [Dt × (1 + g)] / (R – g) This means that since we will use the dividend in Year 10, we will be finding the stock price in Year 9. The dividend growth model is similar to the PVA and the PV of a perpetuity: The equation gives you the PV one period before the first payment. So, the price of the stock in Year 9 will be: P9 = D10 / (R – g) = $12.00 / (.135 – .05) = $141.18

FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 6 of 16 TRU Open Learning The price of the stock today is simply the PV of the stock price in the future. We simply discount the future stock price at the required return. The price of the stock today will be: P0 = $141.18 / 1.1359 = $45.16 Question 5 (30 marks) Solar Tech Inc. must choose between two mutually exclusive projects: A and B. Both have a 10% required rate of return. Consider the following on projected cash flows: Year A B 0 $ ‐ 50,000 $ ‐ 100,000 1 9,000 60,000 2 16,000 30,000 3 40,000 30,000 a. If you apply the payback criterion, which investment will you choose? Why? (5 marks) b. If you apply the NPV criterion, which investment will you choose? Why? (5 marks) c. If you apply the profitability index criterion, which investment will you choose? Why? (5 marks) d. What is the internal rate of return for each project? (5 marks) e. At what required rate of return would management be indifferent as to which project to choose? (5 marks) f. Based on your answers to the questions above, which project will you finally choose? Why? (5 marks)

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FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 7 of 16 TRU Open Learning Solution a. PB(A) = 2+25000/40000 = 2.63 PB(B) = 2+10000/30000 = 2.33 Project B has a shorter payback period, so choose B. b. NPV(A) = ‐ 50000+9000/1.1+16000/1.12+40000/1.113 = $1,458 NPV(B) = ‐ 100000+60000/1.1+30000/1.12+30000/1.113 = $1,878 Calculator: A 10 I/yr CF0 50,000 ‐ CF1 9,000 CF2 16,000 CF3 40,000 NPV = $1,458. B 10 I/yr CF0 100,000 ‐ CF1 60,000 CF2 30,000 CF3 30,000 NPV = $1,878. Project B has a higher NPV, so choose B. c.

FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 8 of 16 TRU Open Learning PI(A) = (9000/1.1+16000/1.12+40000/1.113)/50000 = 1.03 PI(B) = (60000/1.1+30000/1.12+30000/1.113)/100000 = 1.02 Project A has higher PI, so choose A. d. A CF0 50,000 ‐ CF1 9,000 CF2 16,000 CF3 40,000 IRR = 11.31% B CF0 100,000 ‐ CF1 60,000 CF2 30,000 CF3 30,000 IRR = 11.22% e. A B Difference $ ‐ 50,000 $ ‐ 100,000 ‐ 50,000 9,000 60,000 51,000 16,000 30,000 14,000 40,000 30,000 ‐ 10,000

FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 9 of 16 TRU Open Learning Calculator: CF0 50,000 ‐ CF1 51,000 CF2 14,000 CF3 10,000 ‐ IRR = 10.99% f. Although A has a marginally higher PI, would prefer to choose B based on NPV and payback. If the projects were not mutually exclusive, then both are viable projects. Question 6 (15 marks) NW Power Corp., who has a 35% tax rate, presented you with the following information:  Debt: 10,000 of 6.4% coupon bonds outstanding, $1,000 par value, 25 years to maturity, and selling for 108% of par; the bonds make semi ‐ annual payments.  Common stock: 495,000 shares outstanding and selling for $63 per share; the beta is 1.15.  Preferred stock: 35,000 outstanding shares of $3.50 preferred stock currently selling for $72 per share.  Market: 7% market risk premium and 3.2% risk ‐ free rate. Calculate the weighted average cost of capital. Solution We will begin by finding the market value of each type of financing. We find: MVD = 10,000($1,000)(1.08) = $10,800,000 MVE = 495,000($63) = $31,185,000 MVP = 35,000($72) = $2,520,000

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FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 10 of 16 TRU Open Learning And the total market value of the firm is: V = $10,800,000 + 31,185,000 + 2,520,000 = $44,505,000 Now, we can find the cost of equity using the CAPM. The cost of equity is: RE = 0.032 + 1.15(0.07) = 0.1125 or 11.25% The cost of debt is the YTM of the bonds, so: P0 = $1,080 = $32(PVIFAR%,50) + $1,000(PVIFR%,50) R = 2.895% YTM = 2.895% × 2 = 5.790% And the after ‐ tax cost of debt is: RD = (1 – 0.35)(0.0579) = 0.037635 or 3.764% The cost of preferred stock is: RP = $3.50/$72 = 0.04861 or 4.861% Now we have all of the components to calculate the WACC. The WACC is: WACC = 0.03764(10,800,000/44,505,000) + 0.1125(31,185,000/44,505,000) + 0.04861(2,520,000/44,505,000) = 0.0907 or 9.07% Notice that we did not include the (1 – tC) term in the WACC equation. We used the after ‐ tax cost of debt in the equation, so the term is not needed here.

FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 11 of 16 TRU Open Learning Question 7 (10 marks) Rathtrevor Corp. presented you with the following information: Rathtrevor Corporation Statement of Financial Position December 31, Years 5 and 4 ($ thousands) Assets Year 5 Year 4 Cash $215 $210 Accounts receivable 310 355 Inventory 328 507 Property, plant and equipment, net 6,527 6,085 Total assets $7,380 $7,157 Liabilities and Shareholder’s Equity Liabilities Current liabilities Accounts payable $298 $207 Notes payable 1,427 1,715 Total current liabilities 1,725 1,922 Long term liabilities Bonds payable 2,308 1,987 Total liabilities 4,033 3,909 Shareholder’s Equity Common shares 1,000 1,000

FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 12 of 16 TRU Open Learning Retained earnings 3,347 2,248 Total Shareholder’s Equity 3,347 3,248 Total Liabilities and Shareholder’s Equity $7,380 $7,157 Rathtrevor Corporation Income Statement Year Ended December 31, Year 5 ($ thousands) Sales $4,053 Cost of goods sold 2,780 Gross profit 1,273 Other Expenses: Depreciation $550 Interest 502 1,052 Income before tax 221 Tax 75 Net income $146 Other information: Rathtrevor also paid $47,000 in dividends.

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FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 13 of 16 TRU Open Learning Calculate the following ratios for Year 5: a. Current ratio (1 mark) b. Quick ratio (1 mark) c. Inventory turnover (1 mark) d. Receivables turnover (1 mark) e. Day’s sales in receivables (1 mark) f. Debt ratio (1 mark) g. Times interest earned ratio (1 mark) h. Net profit margin (1 mark) i. Return on assets (1 mark) j. Return on equity (1 mark) Solution a. Current ratio 853 / 1725 = .49 b. Quick ratio 525 / 1,725 = .30 c. Inventory turnover 2,780 / 328 = 8.48 d. Receivables turnover 4,053 / 7,380 = 13.07 e. Day’s sales in receivables 365 / 13.07 = 28 f. Debt ratio 4,033 / 7,380 = .546 g. Times interest earned ratio 723 / 310 = 1.44 times h. Net profit margin 146 / 4,053 = 3.60% i. Return on assets 146 / 7,380 = 1.98% j. Return on equity 146 / 3,347 = 4.36%

FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 14 of 16 TRU Open Learning Question 8 (10 marks) Mazie’s Clothing Inc. is analyzing two machines to determine which one they should purchase. The company requires a 14% rate of return, each machine belongs in a 30% CCA class, and the firm’s tax rate is 35%. Machine A has a cost of $290,000, annual operating costs of $8,000, and a 3 ‐ year life. Machine B costs $180,000, has annual operating costs of $12,000, and has a 3 ‐ year life. Both machines have zero salvage value at the end of their useful lives. The company will use the accelerated CCA deduction of 1.5 times the rate in Year 1. Ignore the tax effect of the machines after Year 3. Which machine should Mazie ʹ s Clothing Inc. purchase? Why? Show your calculations. Solution Note that this scenario does not provide revenues, so you cannot calculate tax expense or profit. It is only about minimizing costs. Total costs for Machine B are less than A by $77,627. A CCA Year 1 CCA Year 2 CCA Year 3 290,000 159,500 111,650 30% 30% 30% 87,000 1.5 130,500.0 47,850 33,495 Tax saved @ 35% 45,675.0 16,747.5 11,723.3 B CCA Year 1 CCA Year 2 CCA Year 3

FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 15 of 16 TRU Open Learning 180,000 99,000 69,300 30% 30% 30% 54,000 1.5 81,000 29,700 20,790 Tax saved @ 35% 28,350.0 10,395.0 7,276.5 A 14% i/yr 14% Or calc PV Investment (290,000) CF0 (290,000) Yr 1 Operating costs (8,000) Tax savings 45,675 37,675 CF1 33,048 Yr 2 Operating costs (8,000) Tax savings 16,748 8,748 CF2 6,731 Yr 3 Operating costs (8,000) Tax savings 11,723 3,723 CF3 2,513 NPV (247,708) (247,708)

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FNCE 2121 • PRACTICE EXAMINATION • ANSWER KEY 16 of 16 TRU Open Learning B 14% i/yr 14% Investment (180,000) CF0 (180,000) Yr 1 Operating costs (12,000) Tax savings 28,350 16,350 CF1 14,342 Yr 2 Operating costs (12,000) Tax savings 10,395 (1,605) CF2 (1,235) Yr 3 Operating costs (12,000) Tax savings 7,277 (4,724) CF3 (3,188) NPV (170,081) (170,081)