MOS 3310 Corporate Finance Midterm Exam

QUESTION 1 (15 marks)

QUESTION 1 (A) What is the agency problem faced by large corporations?

What is the agency problem faced by large corporations? Give three examples of the agency problem from corporations. (5 marks)

Solution – Question 1(A)

The conflict or disagreement between agents and principals is called the agency problem. For instance, they might choose actions that increase their pay or job security without considering the long-term effect on shareholder wealth.

To increase their compensation, for as, by receiving more significant bonuses or stock options, management may make risky investments or purchases while oblivious to the possible harm they could cause to shareholders. Financial instability and value destruction may result from this behavior.

Giving managers access to asymmetric information might allow them to falsify or selectively disclose information to their benefit, such as by exaggerating performance, hiding issues, or engaging in insider trading. Due to incomplete or inaccurate information, shareholders may experience losses that will affect their ability to make wise investment decisions.

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QUESTION 1 (B) Briefly describe three (3) different measures that could minimize or resolve agency problems

Briefly describe three (3) different measures that could minimize or resolve agency problems and ensure cooperative and ethical behavior. Describe how each measure would be effective. (6 marks)

QUESTION 1 (C) Explain why managers should use ethical decision making

Explain why managers should use ethical decision making as a way to increase the profitability of a firm. (4 marks)

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QUESTION 2 (14 marks)

A) What is the goal of a company and therefore all managers and employees? Briefly discuss how to measure achievement of this goal. (2 marks)

B) What are the functions of financial markets? (2 marks). Describe what a financial intermediary is and does. (2 marks)

C) Distinguish regarding financial markets. Briefly explain and give an example in each case. (4 marks)

i) Primary versus Secondary Market

ii) Money Market versus Capital Market

D) Define what cost of capital is and describe why it is important. (2 marks)

E) You have an opportunity to invest for 10 years at a guaranteed 8% rate of return. What is the opportunity cost of capital? (2 marks)

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QUESTION 3 (10 marks)

A) Vegas Knight Corp. will pay a year-end dividend of $4.50 per share which is expected to growth at a rate of 4% indefinitely. The discount rate is 10%

i) What is the stock currently selling for? (Po) (2 marks)

Dividend Per Share 4.5

Growth Rate 4%

Discount Rate 10%

Current Selling Price $78.00 4.5 x 1.04 / (10% -4%)

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ii) If earnings are $5.00 a share. What is the implied value of growth opportunities? (3 marks)

B) Panthers Corp has been growing at a rate of 15% per year, and you expect this growth rate in earnings and dividends to continue for another 3 years.

i) If the last dividend paid was $2, what will the next dividend be? (1 mark)

ii) If the dividend rate is 10% and the steady growth rate after 3 years is 5%. What should the stock price be today? (4 marks) Hint: 10% is the required return.

QUESTION 4 (16 marks)

A) Your younger sister, Lizbeth, will start college in five years. She has just informed your parents she wants to go to Cambridge University of which will cost $20,000 per year for four years (assumed to come at the end of the year). Anticipating Lizbeth’s ambitions, your parents started investing $2,500 per year five years ago and will continue to do so for five more years.

REQUIRED:

How much more will your parents have to invest each year for the next five years to have the necessary funds for Lizbeth’s education? Use 10% as the appropriate interest rate (discount rate) throughout this problem. (6 marks)

B) You just won the lottery! Your prize can be either taken in the form of $50,000 at the end of each of the next 20 years (ie $1,000,000 over 20 years) or as a lump sum of $550,000 paid immediately.

i) If you expect to earn 5% annually on your investment over the next 20 years, which alternative should you take? Why? (3 marks)

ii) Would your decision change if you could earn 7% instead? Why? (2 marks)

C) A factory costs $450,000. You forecast it will produce cash inflows of $120,000 in

year 1, $180,000 in year 2 and $300,000 in year 3. The discount rate is 12%. Is the factory a good investment? Show your calculations. (3 marks). Does your decision change if the discount rate is 15%? Show your calculations. (2 marks)

QUESTION 5 (15 marks)

TRUE or FALSE

Are the following statements True or False? Provide a single example to support your answer (use a $1000 Bond). Each part is worth 3 marks (1 mark for the correct answer and 2 marks for the example.

a) If interest rates rise, bond prices rise.

b) If the bond’s yield to maturity is greater than its coupon rate, the price is less than the bond’s face value.

c) High-coupon bonds of a given maturity sell for higher prices than otherwise identical low-coupon bonds.

d) An investor who owns a 10%, 5 year Canada Bond is wealthier if interest rates rise from 4% to 5%.

e) If interest rates change, the price of a high-coupon bond changes proportionately more than the price of a low-coupon bond of the same maturity and default risk.

QUESTION 6 (10 marks)

A) Martin and Jessica are dreaming about taking a trip around the world when they sell their jewelry store in the future. They decided to put aside $4,000 each year in a low risk investment that earns 4% interest. In 5 years they will receive a one-time gift of $20,000 which can also be invested until they travel.

i) How much money will they have accumulated 40 years from now when they plan on their once in a life time trip? (3 marks)

ii) If their goal is to travel and have some savings left they want to have a $1,2000,000 of savings, how much extra do they need to save every year?

(3 marks)

B) i) Use the Rule of 72 to figure out how long it will take for your money to quadruple

(4 times) in value if the interest rate for investments is 8% per year. (2 marks)

ii) What is the difference between effective annual interest rate (EAR) an annual percentage rate (APR)? (2 marks)

QUESTION 7 (10 marks)

A) Summer Bay Corp. reinvests 30% of its earnings in the corporation. The stock sells for $25, and the next dividend will be $1.25 per share. The discount rate is 7.5%. What is the rate of return on the company’s reinvested funds? (3 marks)

B) Whistler Corp will pay a dividend of $5 per share in year 1. It sells a $60 share, and firms in the same industry provide an expected return of 14%. What must be the expected growth rate of the company’s dividend? (2 marks)

C) Briefly discuss the Efficient Market Theory. (2 marks). How does competition among investors lead to efficient markets? (3 marks)

SHOW ALL CALCULATIONS

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