Finance quiz sample exam - Calculation type questions:

Q1. Manufacturing, Inc is planning a $1,000,000 expansion of its production facilities. The expansion could be financed by the sale of $1,250,000 in 8% notes or by the sale of $1,250,000 in capital stock.

This would raise the number of shares outstanding from 50 000 to 75 000. Sigma Manufacturing pays income taxes at a rate of 30%.

Required:

1. Suppose that income from operations is expected to be $400,000 per year for the duration of the proposed debt issue. Should Sigma be financed with debt or stock? Explain your answer.

2. Suppose that income from operations is expected to be $ 220,000 per year for the duration of the proposed debt issue, Should Sigma use debt or equity financing? Explain your answer.

3. Suppose that income from operations varies from year to year but is expected to be above $ 300,000 for 40% of the time and below $ 300,000 for 60% of the time. Should the Sigma finance with notes or with stock? Explain your answer.

4. As an investor, how would you use the accounting information to evaluate risk of excessive leverage? What other information would be useful? Explain (Hint which financial ratios would be of help?).

Q2. Investment Fund Angel, Ltd has total capital of £ 500 million. It is currently invested in five stocks:

a) Calculate the beta coefficient of the fund β_Fund.

b) Risk-free rate is now 5 per cent (R_f = 5 %), and expected market return is 12 per cent (R_M =12 %). Calculate the expected return of the fund k_Fund.

c) Draw the security market line (SML) of the fund portfolio.

d) Now suppose that another £ 50 mil. have been invested into the fund. Portfolio manager receives an offer to invest this money in a new stock G. Manager was told, that the stock has return 18 per cent p.a. (k_G = 16 %) and risk β_G = 2.5. Should the new stock be purchased?

e) At what expected rate of return should the manager be indifferent to purchasing the stock G?

f) Assume that the fund manager decides to invest £ 50 mil. into another asset H instead of G. This asset H has risk β_H = 2.5 and return k_H = 22,5 per cent p.a.

- Will this investment have an impact on the risk of the fund portfolio β_Fund?

- Will it modify the expected return of this portfolio k_Fund? 

- How will the SML of the portfolio be modified?

Q3. Pear Computers, Ltd is a suitable target for Lemon Corporation.

Capital structure of Pear is composed of 40 % long-term debt and 60% equity capital. In case the acquisition goes through Lemon Corp wants to increase Pear's indebtedness to 45 %. After tax cost of debt of Pear is 8 %, and it is assumed that it will not change. Cost of common equity will be approx. 18 % after the merger. The present value of Pear's debt is $ 40 mil. Lemon Corp wants to pay for Pear's shares $450 mil in cash and common shares. At the same time it will assume all liabilities of Pear. Today's total value of Pear's shares is $ 200 mil.

Cost of goods sold before depreciation represent 60 % of sales. The average tax rate is 45 %. Tax shields are in years 2012-2016 as follows: $30 mil., $21 mil.  $15 mil. and $10 mil. From the year 2016 will the tax shield be constant of $ 4 mil.

Further information about the company is in the following table ($ mil).

Required:

a) Calculate the cost of capital of Mango with the new capital structure

b) Calculate the NPV of this acquisition

c) Decide whether ABC Corp should purchase Mango. Ltd.