EXAMINATION PAPER
FACULTY OF BUSINESS AND LAW
Department of Finance
TEMPLATE FOR MAF203 EXAM
Unit Code:
MAF203
Unit Name:
Business Finance
Writing Time:
2 hours
Reading Time:
15 Minutes
This examination is CLOSED BOOK.
Instructions for Candidates:
1.
This paper consists of 7 questions.
2.
This paper carries 60 marks.
3.
ALL QUESTIONS MUST BE ANSWERED.
4.
A formula sheet along with present value and future value tables
are provided at the end of this examination paper.
5.
Both scientific and financial calculators are allowed for this
examination.
THIS PAPER MUST REMAIN IN THE EXAMINATION ROOM.
Materials authorised for this examination must be in accordance with
Deakin University policy.
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[REVISION QUESTIONS TO ASSIST EXAM PREPARATION]
Question 1
(a) Luke and Monica are proud parents of baby Lily who is 2 years old. They want to send
Lily to Presbyterian Ladies’ College (PLC), a prestigious private girl school, when Lily
enters secondary college. They estimate that to fully fund the cost of Lily’s secondary
education they will need to have $120,000 at the time Lily is 13 years old. They currently
have $10,000 in an education fund for Lily which will be invested at 8% per annum until she
reaches 13. They also intend to make monthly contributions into an investment account that
pays 12% per annum (i.e 1% per month) with annual compounding. What is the monthly
contribution if they were to achieve their saving objective of $120,000 when Lily is 13 years
old?
(b) James Holloway has just won a television game show. There are two ways in which
James can receive his price:
Option 1: a once-off payment of $65,000 in 12 months
Option 2: a payment of $5000 a month for 12 months with the payment increasing by 0.5%
every month.
Assuming that the monthly discount rate is 1.5% and that interest rate compounds monthly,
which option is financially better for James?
Hint
a. The FV of $5000 is 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 = 10,000 × (1.008)11 = $23,316.19
The balance required for Lily’s cost of secondary education is:
120,000 – 23, 316.39 = $96,683.61
The monthly contribution is therefore:
𝐹𝑉𝐴
96,683.61
𝑃𝑀𝑇 =
=
𝑛
[(1 + 𝑖) − 1]/𝑖 [(1 + 0.01)132 − 1]/0.01
b. PV of Option 1 is 𝑃𝑉 = 𝐹𝑉/(1 + 𝑖)𝑛 =65,000 /(1 + 0.015)12= 54,365.18
PV of Option 2 is
𝐶𝐹1
1+𝑔 𝑛
𝑃𝑉𝐴 =
[1 − (
) ] = $56,013.02
(𝑖 − 𝑔)
1+𝑖
Option 2 is therefore better for James.
Question 2
(a) Why is share valuation more difficult than bond valuation?
(b) HRL Technologies stocks currently sell for $29 per share. The company last paid a
dividend of $2.50 and the dividend is expected to grow at a perpetual rate of 2% per annum.
Investors require a 12% return on HRL Technologies stocks? What is the intrinsic value of
this stock and whether you would consider HRL Technologies a good buy at $29 per share?
Hint
a.
 In contrast to coupon payments on bonds, size and timing of dividend
cash flows are less certain
 Ordinary shares are true perpetuities in that they have no final maturity
date
 Unlike rate of return, or yield, on bonds, rate of return on ordinary
shares cannot be observed directly
b. The intrinsic value of the stock is:
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𝐷0 (1 + 𝑔) 2.5 ∗ (1 + 0.02)
=
= $25.50
𝑘−𝑔
0.12 − 0.02
The current market value is greater than the intrinsic value so it’s not a good buy.
𝑃𝑜 =
Question 3
(a) Do you think CSR activities contradict corporations’ goal of shareholders’ wealth
maximisation? Why or why not?
(b) Renfro Rentals has issued bonds that have a 10% coupon rate, payable semi-annually. The
bonds mature in 8 years, have a face value of $1,000, and a yield to maturity of 8.5%. What is
the price of the bonds?
(c) A stock is trading at $80 per share. The stock is expected to have a year- end dividend of
$4 per share, and it is expected to grow at some constant rate g throughout time. The stock’s
required rate of return is 14%. If markets are efficient, what is your forecast of g?
Question 4
(a) McDowell Industries sells on terms of 3/10, net 30. Total sales for the year are $912,500.
Forty percent of customers pay on the 10th day and take discounts; the other 60% pay, on
average, 40 days after their purchases.
 What is the days sales outstanding?
 What is the average amount of receivables?
 What would happen to average receivables if McDowell toughened its collection
policy with the result that all non-discount customers paid on the 30th day?
(b) The Zocco Corporation has an inventory conversion period (i.e. DSI) of 60 days, an
average collection period (i.e. DSO) of 38 days, and a payables deferral period (i.e. DPO) of
30 days. Assume that cost of goods sold is 75% of sales.
 What is the length of the firm’s cash conversion cycle?
 If Zocco’s annual sales are $3,421,875 and all sales are on credit, what is the firm’s
investment in accounts receivable?
 How many times per year does Zocco turn over its inventory?
Hint
a.
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i.
0.4(10) + 0.6(40) = 28 days.
ii.
$912,500/365 = $2,500 sales per day.
$2,500(28) = $70,000 = Average receivables.
iii.
0.4(10) + 0.6(30) = 22 days.
$912,500/365 = $2,500 sales per day.
$2,500(22) = $55,000 = Average receivables.
Sales may also decline as a result of the tighter credit. This would further reduce receivables. Also,
some customers may now take discounts further reducing receivables.
b.
Cash
i.
conversion
cycle
Inventory
Receivable s Payables
= conversion  collection  deferral
period
period
period
= 60 + 38 – 30
= 68 days.
ii.
Average sales per day = $3,421,875/365 = $9,375.
Investment in receivables = $9,375  38 = $356,250.
iii.
Inventory turnover = 365/60 = 6.08.
Question 5
(a) BugBusters Australia is considering replacing a machine with a new machine that has a
four-year life. The purchase of this new machine has a cost of $700,000, shipping cost of
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$80,000, and an installation charge of $20,000. This machine will not require any additional
working capital. The "old" project can be salvaged for $120,000 currently. The "old" machine
has four years useful life remaining with a depreciation expense of $20,000 for each of those
years and was originally purchased six years ago for $200,000. The "new" project will not
generate additional revenues, but will decrease operating expenses by $90,000 for each year
of the four-year project. For tax purposes, the new equipment will be fully depreciated on
straight line basis over next four years. The company is subject to a marginal tax rate of 40%.
The salvage value at the end of the fourth year for the "new" project is expected to be
$50,000.
 What is the initial cash outflow?
 What are the interim incremental net cash flows for each year?
 What is the terminal year cash flow?
(b)From a finance manager’s perspective, what are the advantages and disadvantages of using
debt financing compared with equity financing?
Hint.
(a)
Initial cash flow at t=0:
Purchase: -$700,000
Shipping and installation: -$100,000
Depreciable basis = $800,000
Old machine after taxes = $120,000 - ($120,000-$80,000)(.40) =
$104,000
Initial Cash flow = -$800,000 + $104,000 = -$696,000
Depreciation:
Year 1 to 4: $800,000 / 4 = $200,000 / yr
Yearly revenue change:
Decrease operating expenses of $90,000
Incremental net cash flow at t=1 , 2, 3 & 4:
Revenue change: $90,000
Depreciation: -$180,000
Net change BT = -$90,000
Taxes @ 40% = -$36.000
Net change AT = -$54,000
Incremental net cash flow (after depreciation) = -$54,000 + $180,000= $126,000.
Terminal cash flow at t=4:
Cash flow from new machine after taxes = $50,000 (1-.40) = $30,000
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Terminal cash flow = $126,000+ $30,000 = $144,000.
b.
Question 6
(a)
If a firm went from zero debt to successively higher levels of debt, why would you
expect its stock price to first rise, then hit a peak, and then begin to decline?
(b)
Schweser Satellites Ltd. produces satellite earth stations that sell for $100,000 each.
The firm’s fixed costs are $2 million, 50 earth stations are produced and sold each year,
profits (EBITDA) total $500,000, and the firm’s assets (all equity financed) are $5 million.
The firm estimates that it can change its production process, adding $4 million to investment
and $500,000 to fixed operating costs. This change will:
 reduce variable costs per unit by $10,000 and

increase output by 20 units

the sales price on all units will have to be lowered to $95,000 to permit sales
of the additional output.
The firm has tax loss carry forwards that render its tax rate zero, its cost of equity is 16%, and
it uses no debt.



What is the incremental profit (EBITDA)?
Would the firm’s break-even point (on cash flow basis) increase or decrease if it made
the change?
Would the new situation expose the firm to more or less business risk than the old
one? Explain based on firm’s cash flow DOL.
Hint
a. The tax benefits from debt increase linearly, which causes a continuous increase in the firm’s value
and stock price. However, financial distress costs get higher and higher as more and more debt is
employed, and these costs eventually offset and begin to outweigh the benefits of debt.
b. Determine the variable cost per unit at present, V:
Profit
$500,000
50(V)
V
= P(Q) - FC - V(Q)
= ($100,000)(50) - $2,000,000 - V(50)
= $2,500,000
= $50,000.
Determine the new profit level if the change is made:
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New profit
= P2(Q2) - FC2 - V2(Q2)
= $95,000(70) - $2,500,000 - ($50,000 - $10,000)(70)
= $1,350,000.
Determine the incremental profit:
Profit = $1,350,000 – $500,000 = $850,000.
ii. The change would increase the breakeven point:
Old:
QBE =
$2,000,000
F
=
= 40 units.
P  V $100,000  $50,000
New:
QBE =
$2,500,000
= 45.45 units.
$95,000  $40,000
There break even point increases.
ii. It is impossible to state unequivocally whether the new situation would have more or less
business risk than the old one. We would need information on both the sales probability
distribution and the uncertainty about variable input cost in order to make this
determination. However, since higher DOL refers to greater business risk therefore Old
situation has greater business risk:
DOL Old:
1+
$2,000,000
FC
= 1+
=5
EBIDTA
$500,000
New:
1+
FC 2
$2,500,000
= 1+
= 2.85
EBIDTA 2
$1,350,000
Question 7
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(a)
The Rogers Company is currently in this situation: (1) EBIT = $4.7 million; (2) tax
rate, T = 40%; (3) value of debt, D = $2 million; (4) cost of debt, rd = 10%; (5) cost of equity,
rs = 15%; (6) number of equity stocks outstanding, n = 600,000; and stock price, P = $30.
The firm’s market is stable and it expects no growth, so all earnings are paid out as dividends.
The debt consists of perpetual bonds.
 What is the total market value of the firm’s stock, S, and the firm’s total
market value, V?
 What is the firm’s weighted average cost of capital?
Suppose the firm can increase its debt so that its capital structure has 50% debt, based on
market values (it will issue debt and buy back stock). At this level of debt, its cost of equity
rises to 18.5% and its interest rate on all debt will rise to 12% (it will have to call and refund
the old debt). What is the WACC under this capital structure?
 What’s the new market value of the firm?
(b) State and explain MM's (Modigliani and Miller) Proposition 2 on capital structure.
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