Georgia State University
Robinson College of Business
______
Cases and Readings in Corporate Finance Professor D. C. Nachman
Sample Final Exam
This exam is open book, open notes, no copying, no talking or other form of communication (keep your answer sheet covered). Calculators are permitted. There is a mix of twenty-five qualitative and quantitative multiple-choice questions worth four points each. Give the single most correct answer.
1. Which of the following are true regarding risk neutral valuation?
a. It is implied by the absence of arbitrage opportunities.
b. It implies the absence of arbitrage opportunities.
c. It is silly because no one is risk neutral.
d. All of the above.
e.* a and b.
2. A European put option on a stock is like
a.* a short position in the stock that levers a long position in the riskless asset.
b. a levered short position in the stock.
c. a levered long position in the stock.
d. all of the above.
e. none of the above.
Use the following information to answer Questions 3-5.
The Mayroot Corporation is looking at a courtyard motel project. In the next year, it will be determined if courtyard motels are popular or not. If courtyard motels are popular, the motel will be worth $13 million immediately following construction. If courtyard motels are not popular, the motel will be worth $9 million immediately following construction. The courtyard motel would be worth $10 million if constructed today. Construction takes no time, but the construction cost is $9.7 million. The risk-free rate of return is 5%.
3. What is the NPV of constructing the courtyard motel today?
a.* $300,000.
a. $400.000.
b. $2,000,000.
c. $10,000,000.
d. $11,000,000.
4. What is the risk neutral probability that courtyard motels will be popular?
a. 0.250.
b.* 0.375.
b. 0.545.
c. 0.580.
d. 0.675.
5. Suppose Mayroot has the option to wait a year before it decides whether or not to construct the courtyard motel, but all other details regarding the payoffs and costs are the same. Suppose the answer to question 4 is b. What is the value today of waiting one year? (Answers below are rounded to the nearest $1,000 with $500 rounding up to $1,000).
a. $10,417,000.
b. $4,643,000.
c.* $1,179,000.
d. $957,000.
e. $638,000.
6. When a waiter asked Yogi Berra (Baseball Hall of Fame catcher for the New York Yankees) whether he wanted his pizza cut into four slices or eight slices, Yogi replied: “Better make it four, I don’t think I can eat eight.” Yogi’s quip helps convey the basic insight of Modiliani and Miller that
a. given the size of the pizza, the more the slices you cut it in the more pizza you get.
b. the larger the pizza, the more slices you can cut it in.
c.* given the firms investments, the value of the firm is unaffected by whether the
liability side of the balance sheet is sliced to include more or less debt.
d. given the firms liabilities, the more debt the firm has the more investments it can make.
e. given the firms investments, the value of the firm is increased if the liability side of the
balance sheet is sliced to include more debt because debt is cheaper than equity.
7. Financial and commodity price risks all involve an upside and a downside. In managing such a risk, a distinction is made between hedging the risk and insuring the risk. The essence of this distinction is that
a. hedging the risk involves selling off the downside of the risk while insuring the risk
involves using an insurance agent.
b. hedging the risk involves using a hedge hog while insuring the risk means selling off
the upside of the risk.
c.* hedging the risk involves selling off the upside to induce someone to insure you against the downside while insuring the risk means paying someone to take the downside.
d. hedging the risk involves selling off the upside to induce someone to insure you against the downside while insuring the risk means paying someone to take the upside of the risk.
e. All of the above.
8. Which part of the value chain for gold mining firms is least likely to be a source of competitive or comparative advantage?
a.* sales.
b. develop mine process.
c. exploration.
d. acquisition.
f. none of the above.
9. The trade-off theory of capital structure states that a firm’s debt-equity decision involves a trade-off between
a. accounting earnings before taxes and risk.
b. using accelerated depreciation and interest deductions.
c. earnings per share and dividends per share.
d.* interest tax shields and costs of financial distress.
e. rapid growth of earnings and accelerated depreciation.
10. Which of the following may make debt financing a negative NPV transaction for a firm?
a. Interest tax shields.
b.* Incentives to forego value creating investments.
c. Incentives to shift the risk of investments to lower risk.
d. All of the above.
e. None of the above.
Use the following information to answer questions 11-13.
Carr Mfg. is a simple one-year project with the following characteristics. At the beginning of the year, a cash outlay of $100,000 is required. One year later the project produces cash flows in the form of EBIT of $245,000 with objective probability 0.6 or $150,000 with probability 0.4. Depreciation and salvage values are zero. The corporate tax rate is 38%, the required rate of return on a one-year investment of comparable risk is 15%, and the one-year risk free rate of return is 8%. Answers below are rounded to the nearest dollar with $.50 rounding up to $1.00 or to the nearest 100th of a percent.
11. What is the maximum amount (in terms of face value) of riskless debt Carr could use to finance itself?
a. $75,445.
b.* $88,605.
c. $90,291.
d. $115,545.
e. $86,111.
12. Carr finances itself with debt with face value of $80,000 and an equity contribution of $20,000. What is the market value of Carr immediately after the financing (at the beginning of the one year)?
a. $111,600.
b. $118,000.
c. $102,432.
d.* $113,852.
e. $114,062.
13.Assume that the answer to question 12 is d. What is the required rate of return on the assets of Carr Mfg.?
a.* 14.86%.
b. 10.08%.
c. 9.40%.
d. 7.94%.
e. 6.97%.
14. For American Barrick, which of the following were offered as a rationale for managing gold price risk?
a. It allows us to take advantage of the decade’s opportunities.
b. It allows us to separate the bet on operating efficiency from the bet on gold price risk.
c. It allows us to reduce the firm’s free cash flow.
d. It allows us to hedge the risk of flooded mines.
e.* a and b.
15. In our class discussion of Diamond Chemicals PLC (B), we looked at the case writer’s suggestion that the £3 million exercise price and the £35 million terminal value of the land associated with the option to purchase the right-of-way “… should be removed from the cash flows of the Rotterdam project.” This suggestion is completely correct, because the option is a separate investment project. However, this suggestion failed to indicate what would replace these cash flows. This failure
a. ignores the value that could be created by exercising this option.
b. raises the work in process inventory of the Rotterdam project.
c. ignores the flexibility to switch from the Japanese process control technology to the German process control technology.
d.* ignores the necessity of a continuous supply of propylene gas for the Rotterdam project and the associated cost of this continuous supply.
e. ignores the possibility that tank cars at Merseyside could be converted for use at Rotterdam.
16. A necessary condition for a participatory option as described in the article “Cover Your Assets” is that
a.* the synthetic forward price in the collar component is less than the forward price.
b. the long call option component has an exercise price less than the synthetic forward
price.
c. the call option part of the collar has an exercise price higher than the long call option component.
d. the put option part of the collar has an exercise price that is larger than the exercise
price of the call option part of the collar.
e. the put option part of the collar must have a market value that exceeds the market value of the call option part of the collar.
17. Basically, the price-support and price-sharing arrangements in the MW Petroleum Corporation (B) case consist of
a. forward contracts between Amoco and Apache for Apache to sell oil to Amoco.
b. put options on the average price of oil given by Apache to Amoco and call options on
the average price of oil and the average price of gas given by Amoco to Apache.
c. forward contracts between Amoco and Apache for Amoco to sell oil to Apache.
d.* put options on the average price of oil given by Amoco to Apache and call options on
the average price of oil and the average price of gas given by Apache to Amoco.
e. forward contracts for the sale of gold by American Barrick.
Use the following information to answer question 18-20.
Homebaked Mining Co. has a two-year spot deferred contract to sell gold. The current one-year risk free rate is 7%, the one-year gold lease rate is 2.8%, and the current spot price for gold is $377.00 per ounce. Answers below are rounded to the nearest cent with $.005 rounding up to $.01.
18. What is the current one-year forward price for gold?
a.* $392.83
b. $385.50
c. $395.85
d. $403.39
e. $399.62.
19. What is the spot deferred contract price for delivery in one year?
a.* $392.83
b. $385.50
c. $395.85
d. $403.39
e. $399.62.
20. At the end of the first year, the gold lease rate for year two is 2.8%, the one-year risk free rate for year two is 7%, and the spot price for gold is $407.50. If the answer to question 19 is a, what is the contract price for the second year of Homebaked’s spot deferred contract?
a. $407.50
b. $424.62
c. $436.03
d.* $408.92
e. $411.39.
21. The APV method, relative to the WACC approach, of adjusting for the side effects of financing has the advantage that
a. the WACC approach yields poor estimates when certain assumptions fail to hold, while APV does not rely on these assumptions.
b. practitioners routinely miscalculate the WACC, while APV is less prone to such miscalculations.
c. APV provides a potentially useful unbundling of components of value not provided by the WACC approach.
d.* all of the above.
e. none of the above.
22. In treating a natural resource extraction investment with output price uncertainty as an option, what is a consequence of operating leverage?
a. The risk of the investment is less than the output price risk, because of the operating
leverage.
b.* The output price risk is magnified by the operating leverage so that the risk of the
investment is greater than the output price risk.
c. In accounting for the operating leverage, one must do careful cost accounting.
d. In accounting for profits, the firm must disclose its use of options and the resulting
operating leverage it creates.
e. None of the above.
Use the following information to answer questions 23-25.
Consider a setting with one period and three possible states of the world, s1, s2, and s3. Wobbly Enterprises, Inc. is a small computer manufacturer whose cash flows depend significantly on the price of silicon chips for RAM (random access memory). Wobbly’s cash flows from assets in place by state, together with the risk neutral probability of each state are given in the following table ($ in millions):
.
Wobbly has debt outstanding with a promised payment due at the end of the period of $6.2 million. The risk-free rate of return is zero.
23. What is the value of Wobbly’s assets in place?
a. $5.40.
b.* $4.65.
c. $21.60.
d. $20.57.
e. $6.05.
24. What is the value of Wobbly’s debt?
a. $5.125.
b.* $4.39.
c. $20.80.
d. $19.81.
e. $6.20.
25. Suppose that Wobbly discovers a new design for RAM that will provide end of period cash flows incremental to those from assets in place as follows:
.
The cost of implementing this new design is $1 million. It must be finance with external funds. Will Wobbly’s shareholders undertake to finance the implementation of this new design?
a. Yes, they would be exchanging equity worth $.26 million for equity worth $1.05 million.
b. Yes, the design NPV is $1 million.
c. No, they would be exchanging equity worth $.26 million and capital worth $2 million
for equity worth $2.05 million.
d. No, they would be exchanging equity worth $4.65 million and capital worth $1 million
for debt worth $5.6 million.
. e.* No, they would be exchanging equity worth $.26 million and capital worth $1 million
for equity worth $1.05 million.