EASTERN ILLINOIS UNIVERSITY
FIN 2710
Calculations
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Present value of an investment
Present value of an annuity
Future value on an investment
Future value of an annuity
Loan payment = amount borrowed/PV factor for interest rate and time to repay
Expected return for an investment = sum of (possible returns x probability of those returns)
Portfolio expected return = sum of (expected return for investment x portfolio weight) for each
investment
Capital asset pricing model: expected return for an asset = risk-free return + (market expected return –
risk-free rate of return) * beta
Bond value = PV of annuity for interest payments + PV of par value at maturity
Bond’s yield to maturity (YTM)
Net present value (NPV) = PV of estimated cash flow – cost of investment
Internal rate of return (IRR) = discount rate which gives future cash flows a NPV of zero
Profitability Index (PI) = present value of cash flows/cost of investment
Cash flows in capital budgeting
a) Initial year (Year 0)
b) Annual after-tax operating cash flow
c) Last year of project
Weighted average cost of capital (WACC) = (equity percentage x equity required return) + (debt
percentage x after-tax debt required return)
a) Cost of debt = after-tax of return (YTM)
i) After-tax rate of return = pre-tax rate of return x (100% - company’s marginal tax rate)
b) Cost of preferred stock = dividend/net price of stock
i) Net price is after paying costs of selling stock (flotation costs)
Cost of existing equity (retained earnings)
a) Methods of estimating the cost of equity
i) CAPM approach: required rate of return = risk-free return + (market expected return – riskfree rate of return) * beta
ii) Dividend growth model: required rate of return = dividend yield + growth rate
Cross exchange rates for foreign currency : the price of a non-U.S. currency expressed in terms of
another non-U.S. currency
Gain or loss on foreign investments as dollar changes in value
Ratios
1) Calculate these ratios:
a) Short-term solvency (used by short-term creditors)
i) Current: current assets/current liabilities
ii) Acid-test (quick): current assets-inventory/current liabilities
b) Long-term solvency (used by long-term creditors and stockholders)
i) Debt: debt (liabilities)/assets
c) Profitability (used by stockholders)
i) Profit margin: net income/sales
ii) Return on assets: net income/assets
iii) Return on equity: net income/equity
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d) Market value (used by stockholders)
i) EPS: net income/number of outstanding shares of common stock
ii) P/E ratio: price of stock/earnings per share
iii) PEG ratio: P/E ratio/growth rate of EPS
e) Other
i) Payout ratio = dividends/net income
ii) Retention ratio = 100% - payout ratio
iii) Percentage change = (current year – prior year)/prior year
2) Interpret these ratios:
a) Beta
Dividend Policy
1) Payment of dividends and dividend dates
2) Relevance of dividend policy
a) Signaling theory
b) Clientele effect
3) Establishing a dividend policy
a) Residual approach
b) Constant payout ratio
c) Stable dividend policy
4) Stock repurchases
5) Stock dividends and stock splits
a) Stock dividends
b) Stock splits
c) Reasons for stock splits and stock dividends
International Business Finance
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Foreign exchange markets
Arbitrage
Impact of a change in the value of the dollar
Purchasing Power Parity
Exchange rate risk
Risks of direct foreign investment
Exam Questions
1) The balance sheet of Gerlick Garlic contains the following information:
Building
$107,000
Accumulated Depreciation ($37,000)
What is the value of the building?
2) The retention ratio for Dennis Ducks has averaged 5% for the past five years. This company is:
_____ growing rapidly
_____ growing slowly
3) Place a checkmark beside each of these items that would increase a company’s cash flow:
_____ inventory decreased during the year
_____ accounts receivable increased during the year
_____ treasury stock decreased during the year
_____ accounts payable decreased during the year
4) The following financial information has been compiled for Reyes Rams as of December 31, 2002.
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Stamp revenue
$ 25,000
Accounts receivable
Cash
2,050
Inventory
Dividends
3,400
Accounts payable
Rent expense
2,400
Depreciation expense
Common stock
6,000
Cost of goods sold
What is the company’s operating cash flow for 2002 assuming the company’s tax rate is 30%?
$1,100
12,000
7,000
6,400
11,100
5) From 1926 – 1999, the average annual return for the investments below were as follows:
Small-company stocks
Large-company stocks
17.6%
13.3%
Long-term corporate bonds
Long-term government bonds
5.9%
5.5%
Which one of these investments should have the least risk?
_____ Small-company stocks
_____ Long-term corporate bonds
_____ Large-company stocks
_____ Long-term government bonds
6) LaPorte Leopards had return on assets in 2002 of 5.6% and return on equity of 5.9%. Based on this
information, the company has:
_____ no debt
_____ a small amount of debt
_____ a large amount of debt
7) Place a checkmark in front of the name of the company that the market expects to have the largest
increase in earnings per share in the future.
Company
Earnings Per Share
Beta
P/E Ratio
Debt Ratio
_____ Arseneau Antlers
$2.12
1.91
17
.94
_____ Wolfe Clothing
$2.88
1.73
28
.63
8) Stockholders would primarily be concerned about which two ratios:
_____ liquidity ratios
_____ solvency ratios
_____ profitability ratios
_____ market value ratios
9) What is the primary goal of the firm from a finance perspective?
10) Plichta Plums had sales of $100,000 in 2000 and $440,000 in 2001. What was the percentage increase
in sales in 2001?
11) If you think stock prices are going to decrease dramatically in the near future you would prefer to own
a stock with a beta of:
_____ -1.1
_____ 1.0
_____ 2.4
12) The following information is available for Donohue Deer. Place a checkmark to indicate whether each
ratio for 2002 is favorable or unfavorable based on the comparison to the industry average.
Donohue
Industry
Favorable
Unfavorable
Deer
Times interest earned ratio
1.21
1.78
WACC
13.2%
14.5%
EPS growth rate
4.32%
2.54%
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13) The following information is available for Prado Pfizz. Place a checkmark to indicate whether each
ratio for 2002 is favorable or unfavorable based on the comparison to the prior year.
2001
2002
Favorable
Unfavorable
Debt to assets ratio
66.3%
72.4%
Profit margin
12.4%
11.5%
14) An article in the January 27, 2003 edition of the Wall Street Journal indicated a University of Michigan
Business School professor purchases stocks which have cash flow from operations and investments that
exceed net income. His investment strategy is consistent with which one of the 10 principles of
finance?
15) An article in the January 27, 2003 edition of the Wall Street Journal indicated stock analysts are
expecting earnings per share for stocks to grow at a 12% rate for the next three to five years. The P/E
ratio for stocks is currently 18.5. eBay’s earnings per share are expected to grow at 40% per year
during the next three to five years. eBay currently has a P/E ratio of 88. Based on the PEG ratio, stock
price of eBay is _______ compared to the overall stock market:
_____ fairly priced
_____ too high
_____ too low
16) List the two primary reasons large businesses use the corporate legal form.
17) In 20 years you plan to retire and buy a house on Lake Tahoe. The house you desire currently costs
$380,000 and is expected to increase in value each year at a rate of five percent. Assuming you can
earn 10 percent annually on your investments, how much must you invest each year at the end of the
next 20 years to be able to buy your dream house when you retire?
18) Marvin Miller was won the Sangamon County Lottery. He is offered a choice between $100,000 today
or receiving $11,000 a year for the next 50 years. If Mr. Miller can earn a 10% rate of return on his
investments, which alternative should he select?
_____ $100,000 Today
_____ $ 11,000 A Year
19) Beulah Bollman wants to have $500,000 when she retires in 40 years. She plans to invest $5,000
today. What rate of return will be required for her funds to grow to the desired amount? Calculate
your answer to the nearest tenth of a percent, for example, 13.1%
20) Bernice Beck wants to have $800,000 when she retires. She plans to invest $3,000 each year. If she
can average a 9% rate of return on her investments, how many years will be required for her funds to
grow to the desired amount? Calculate your answer to the nearest tenth of a year, for example, 13.4
years.
21) Dorothy Dufrenne invested $1,000 a year for 40 years but she withdrew $13,000 from her investments
30 years ago to buy an ATV. If Dufrenne averages a 9% rate of return, how much will she have after
40 years?
22) Your uncle Fred mentions at Easter dinner the March 10, 2003 issue of Business Week indicates the
price of General Electric’s stock price increased or decreased over two percent during 40 percent of the
days the stock was traded in 2002. In 1981, the price of General Electric’s changed by more than two
percent on only 10% of the days the stock traded. Uncle Fred would like your thoughts, as a bright
finance student, on the implications of the large price fluctuations in General Electric’s stock that
now occur on a much more frequent basis.
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23) Bobalouie Burke borrows $200,000 at 6% interest from the Very Last National Bank of Homewood to
buy a home. If he repays the loan over 30 years, what will his annual payments be assuming the
payments are the same every year?
24) The next dividend payment by Tharp Triggers will be $3 per share. Dividends are expected to grow at
4% and the company’s stock currently sells for $50 per share. What is the required rate of return for
the stock?
25) Place a checkmark (√ ) in the table below for the bond(s) that would have a price greater than $1,000.
Place a checkmark (√ ) in the table below for the one bond that would have the highest price.
Face Value
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
Coupon Rate
3%
10%
12%
6%
0%
9%
Required Rate
of Return
(YTM)
6%
5%
21%
6%
6%
4%
Maturity
30 years
30 years
30 years
5 years
10 years
2 years
Price >
$1,000
Highest
Price
26) Using the following data, compute the holding period return for August 1999 for Ben & Jerry’s.
Holding
Period
Month
Price
Return
July
$21.00
August
$19.50
September
$17.19
October
$16.88
27) Based on the information below, calculate the expected return for Chancellor Claws:
Chancellor Claws
Probability
Return
20%
-20%
30%
10%
50%
25%
Martucci Mattresses
Probability
Return
10%
-10%
40%
0%
50%
8%
28) Which stock, Chancellor Claws or Martucci Mattresses, has the highest standard deviation?
29) Assume the stocks listed below trade in an inefficient market. Based on the information available
concerning risk and reward, which stock should you purchase?
Craig Cribs
Tucker Toys
Expected
Return
12%
18%
Beta
1.8
3.0
Berry Beans
10%
.5
30) Your cousin, Norbert “Pork Chop” Nelson, age 26, informs you at Easter dinner he has decided to
invest his retirement funds entirely in corporate bonds. This week he read in the March 10, 2003 issue
of Business Week that investors took $27 billion out of common stock mutual funds during 2002 while
investing $124 billion in bond funds. Pork Chop believes it is “too confusing and too risky” to invest
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in the stock market as he “doesn’t know the difference between a balance sheet and a balance beam”.
So he plans to join the “in crowd” and invest entirely in bonds. As a bright finance student, what
advice would you have for your cousin?
31) Your Aunt Edna, age 59, informs you at Easter dinner she has decided to start saving for retirement.
She plans to retire at age 65 and she would like to have $100,000 at that time. She plans to invest
$2,000 a year in either high-yield bonds or low beta stocks until she retires. As a bright finance
student, what advice would you have for your aunt?
32) Place a checkmark (√ ) in the table below for each of the item(s) that would decrease stock prices
under the dividend growth model.
Decrease stock prices
The required rate of return decreases
The dividend growth rate decreases
33) Boscarino Basketballs paid a $2 dividend last year. At a constant growth rate of 9%, what is the value
of the stock if the investors require a 13% rate of return?
34) How much of Beatrrice Bramwell’s $100,000 portfolio should be invested in Intel stock in the
following portfolio if she desires a portfolio with an overall beta of 1.20?
Expected
Return
Beta
IBM stock
15%
2.0
Treasury bills
2%
35) Indicate whether or not you agree with each of the following rules of investing as stated in your Aunt
Ethel’s best selling book Five Rules of the Filthy Rich.
Agree Disagree
You should only invest in one stock if you have less than $25,000 to invest.
It is better to invest $100,000 by investing $10,000 a month for the next 10
months rather than investing the entire amount today.
Investing for long periods of time reduces the risk of investing in the stock
market.
Selecting individual stocks has a much larger impact on overall portfolio
performance than allocating your portfolio among stocks, bonds, real estate and
other types of assets.
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36) Collins Chickens is considering the purchase of a new chicken fryer. Here is information regarding the
machine:










The chicken fryer costs $48,000.
The company recently completed a study that found the machine should increase sales by $42,000
per year before tax.
The study also indicates sales of fresh chicken will decline by $2,000 per year.
Variable costs are 15% of sales.
The cost to complete the study was $5,000 after-tax.
This machine has an expected life of three years for depreciation purposes and straight-line
depreciation will be used. (Ignore any salvage value when calculating depreciation.)
At the end of year 3 the machine will be sold for $12,000.
To purchase the new machine, it appears the firm would have to borrow $45,000 at 10 percent
interest from its local bank. The company will make principal payments of $15,000 annually for
three years in addition to the annual interest payments.
The company has a 35% tax rate.
It requires a 10% rate of return for the machine.
What is the free cash flow for this project in year 0?
37) What is the annual after-tax free cash flow associated with this project in years 1 and 2?
38) What is the after-tax free cash flow associated with this project in year 3?
39) What is the Net Present Value of this project?
40) Sheppard Swine is considering the purchase of a swine-tenderizing machine. The company is
evaluating two alternative machines: the 007 Pork Packer or the XTZ Swine Smasher. Costs and
projected cash flows are shown in the following table:
Year
007 Pork Packer
XTZ Swine Smasher
0
-40,000
-40,000
1
16,084
-02
16,084
-03
16,084
54,704
What is the Internal Rate of Return for the 007 Pork Packer?
41) What is the Internal Rate of Return for the XTZ Swine Smasher?
42) Dinnerville Diners’ beta is 1.2, the risk-free rate of return is three percent and required rate of return in
the company’s market is 11%. What is the firm’s cost of internal equity using the CAPM approach?
43) The management of Dulny Dials is planning next year’s capital budget. The company projects this
year’s retained earnings will be $9,500. The company’s earnings and dividends are growing at a
constant rate of four percent, the last dividend was $0.70, and the current stock price is $18.00. The
company’s bonds have a coupon rate of 8%, currently trade at $1,070 and mature in 20 years. If the
company issues new stock the flotation costs will be 10%. If the company issues new bonds the
flotation costs will be $70 per bond. The company’s capital structure is 40 percent debt and 60 percent
equity. The firm’s tax rate is 30 percent. What is the company’s after-tax cost of debt?
44) Using the dividend growth model (discounted cash flow approach), what is the cost of retained earnings
for Dulny Dials?
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45) Assuming Dulny Dials retains its current capital structure, what is the company’s weighted average cost
of capital?
46) What is the cost of new equity for Dulny Dials?
47) Fantasia Fans plans to issue $100 par preferred stock with a 5% dividend. The stock is now selling for
$110 and the company must pay flotation costs of six percent of the market price. If Fantasia Fans
marginal tax rate is 40%, what is the cost of preferred stock for the company?
48) Lindwall Linens is issuing a $1,000 par value bond that pays 9 percent annual interest and matures in
20 years. Investors are willing to pay $900 for the bond. Flotation costs will be 10 percent of market
value. What will be the firm’s before-tax cost of debt (YTM) on the bonds to the nearest tenth of a
percent (6.2%, for example)?
49) Your Uncle Elmer informs you at Thanksgiving dinner his company, Elmer’s Glue, has decided to not
build a new horse farm. The Chief Financial Officer of Elmer’s Glue, I. B. Rockhead, a recent Western
Illinois graduate, has calculated the farm will have an initial cost of $500,000 and a “worst case”
scenario NPV of -$1,215 (with a required rate of return of 23%). Mr. Rockhead told Uncle Elmer he
should not pursuit the project since it might have a negative NPV should the worst case assumptions
come true. Uncle Elmer asks if you have any thoughts on this project as a bright finance student.
Discuss the two most important observations you have regarding this project.
50) Your cousin Thelma was recently appointed president of Peoria Porkers. The company is very
profitable and currently has a tax rate of 50%. At Thanksgiving dinner Thelma mentions the company
plans to purchase a new honey wagon. Peoria Porkers plans to sell its old honey wagon for $37,000 to
Springfield Sows and buy a new honey wagon for $48,000. Thelma is very happy with the selling price
for the old honey wagon. (The company paid $56,000 for the honey wagon and has taken $46,000 of
depreciation on the old equipment. The dealer where the company will purchase the new honey wagon
will give Peoria Porkers only $36,000 if they trade-in the old honey wagon on the purchase of the new
honey wagon). The Chief Financial Officer of Peoria Porkers, L. Ice Brains, a recent Southern Illinois
graduate, has calculated the new honey wagon will have an IRR of 7%. He has recommended the
company purchase the honey wagon with $37,000 from the sale of the equipment to Springfield Sows
and use cash flow generated by the company’s operations to fund the remaining $11,000 cost. Mr.
Brains feels the company should not use debt or issue new stock to buy the equipment as the YTM on
the company’s bonds is currently 8% and he estimates the required return on any additional stock sold
by the company would be 11%. Flotation costs would increase the YTM on the bonds to 9% and the
required return on additional stock to 13%. Thelma asks if you have any thoughts on this project as a
bright finance student. Discuss the two most important observations you have regarding this project.
51) Lathrop Lard is evaluating three independent projects shown in the table below.
Project
Lard Smasher
Lard Slasher
Lard Scrubber
Lard Cutter
Lard Cruncher
Cost
Profitability Index
1.04
1.06
1.06
1.07
1.06
$100,000
$200,000
$500,000
$300,000
$100,000
Projects Selected
If the company has only $500,000 to invest, place a checkmark (√) next to the project(s) the company select
under strict capital rationing.
52) Explain the impact the weighted average cost of capital (WACC) has on the value of a firm.
53) Explain how sensitivity analysis is used to evaluate capital budgeting projects.
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Leisten Licorice, Inc.
Balance Sheet
As Of December 31, 2001
Assets:
Cash
Accounts receivable
Inventory
Building
Less: Accumulated Depreciation
Liabilities:
Accounts payable
23,765
71,667
16,765
102,000
-14,000
Owners Equity:
Common stock
Retained earnings
Total
27,453
140,000
200,197
54) What is the quick ratio for Leisten Licorice?
55) What is retained earnings for Leisten Licorice as of December 31, 2001?
56) What is the common stock of Leisten Licorice worth as of December 31, 2001?
57) Nelli Nails has the following capital structure with these required rates of return. Calculate the WACC
for Nelson Nails assuming the company has a 30% tax rate.
Percent
Before-tax cost
Common stock
2%
20.0%
Preferred stock
1%
8.0%
Debt
97%
6.0%
58) What changes would you recommend, if any, to the capital structure of Nelli Nails?
59) Chucktown Chops is evaluating the acquisition of a pickle factory. The factory has a cost of $500,000.
I.B. Dense, the company’s chief financial officer, has calculated the project has an IRR of 3%, an NPV
of $974,500 and a Profitability Index of .64. Discuss two observations you have regarding Mr. Dense’s
calculations.
60) Would increasing the value of the U.S. dollar versus foreign currencies tend to create additional jobs in
the United States?
_____ It would increase jobs.
_____ It would not increase jobs.
61) Vanguard is one of the largest managers of mutual funds in the United States. During the first nine
months of 2002, individuals invested over $34 billion in Vanguard’s mutual funds, more than any other
mutual fund. In the November 25, 2002 edition of Business Week, Vanguard indicated the company’s
mutual fund shareholders had invested over two-thirds of their funds into bonds during 2002. In the
same article, Vanguard indicated they had surveyed their investors and over 70% of them did not know
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what would happen to the price of bonds if interest rates increase. Your observations on the asset
allocation strategy of these investors.
62) Explain how scenario analysis is used to evaluate capital budgeting projects.
63) If you plan to invest funds for more than 20 years, should the majority of the funds be invested in
corporate bonds, Treasury bills or common stocks? Explain why.
_____ Corporate bonds
_____ Treasury bills
_____ Common stocks
64) In recent years the dollar has increased in value against most major foreign currencies. Based on this,
explain whether or not this would be an opportune time to invest in foreign stocks.
65) What are two advantages of investing a portion of your portfolio in foreign stocks?
66) In recent months the dollar has decreased in value against most major foreign currencies. Based on
this, explain whether or not this would be an opportune time to invest in foreign stocks.
67) What are two advantages of investing a portion of your portfolio in foreign stocks?
68) On Thursday, April 24, 2003, Canadian Pacific Railway Ltd. reported earnings per share for the first
quarter of 2003 decreased from 43 cents to 24 cents a share due to high fuel costs and severe winter
weather that disrupted operations. In March, Canadian Pacific had projected first quarter earnings of
21 to 25 cents per share, which was below expectations at that time. Stock analysts’ latest mean
estimate was for earnings of 22 cents a share. (All amounts are in Canadian dollars). How would this
information, released after the stock markets closed on April 24 th, impact the price of Canadian Pacific
stock on April 25th?
_____ The price of the stock should increase since earnings per share were higher than the average estimate
of stock analysts.
_____ The price of the stock should decrease since earnings per share decreased sharply compared to the
prior year.
_____ The price of the stock would not be impacted since it was within the range of earnings per share
projected by the company in March.
69) No See Lite, age 64, has an investment portfolio composed of the following assets:
Stock
Percent of portfolio
Beta
Yield to Maturity
Southwest Airlines
50%
1.4
American Airlines
45%
1.7
Continental Airlines bonds
2%
9.5%
Treasury bills
3%
1.2%
What are the two most important observations you have regarding his investment portfolio?
70) A Russian investor buys 200 shares of Ford for $8,000 U.S. dollars on 11/28 when the Russian Ruble
is worth $.03362 and 29.744 rubles equals one U.S. dollar. One year from now she sells the 200
shares for $8,400 U.S. dollars. If the Russian ruble is worth $.04 in U.S. dollars one year from now,
what is the Russian investor’s gain or loss in rubles?
71) What is the percentage gain or loss for the Russian investor in rubles?
72) Why would a firm declare a 2 for 1 stock split?
73) On Friday, December 6, 2002, the Wall Street Journal reported Alliance Energy, a mid-Atlantic utility,
would stop paying dividends at least through the end of 2003 so it could reduce its debt and improve
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cash flow. The company had previously announced in October it would cut its current dividend of 43
cents per share to no more than 22 cents per share. On the day of the announcement (December 6th) the
price of Alliance’s stock increased from $15.17 to $15.28 per share. Why didn’t the price of the stock
decrease on the day the company announced the elimination of its dividend?
74) On December 14th, 2002, a Congressional Research Service report was released that indicated 75% of
workers age 55 to 64 have retirement savings of less than $56,000. What are you two most important
observations regarding this report?
75) Would the yield-to-maturity on callable bonds issued by IBM be higher, lower or the same as the yieldto-maturity on noncallable bonds issued by IBM if all the bonds matured on the same date? Explain
why.
76) Which of the following sources of capital would have the highest cost to the firm: issuing new bonds,
retained earnings, issuing preferred stock, issuing common stock? Explain why.
77) What are two disadvantages for U.S. companies of investing in foreign capital projects?
78) Should a firm borrow money to maintain its dividend when earnings decrease temporarily? Explain
why or why not.
79) On November 28, 2003, the euro reached a new high of $1.2015 versus the U.S. dollar. Would this
tend to increase or decrease the sale of French wine in the United States?
___ Increase
____ Decrease
80) What are the two most important concepts you have learned in this course? Explain why they are the
most important concepts to you.
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