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AFC2140 Dr Hue Hwa Au Yong Page 1 of 7

Monash University
Semester One Examination 2009
Faculty of Business and Economics
Department of Accounting and Finance

EXAM CODES: AFC2140
TITLE OF PAPER: CORPORATE FINANCE
EXAM DURATION: 3 hours
READING TIME: 10 minutes

THIS PAPER IS FOR STUDENTS STUDYING AT: (office use only - tick where applicable)

Berwick Clayton Peninsula Distance Education Open Learning
Caulfield Gippsland Sunway Hong Kong Other (specify)

During an exam, you must not have in your possession, a book, notes, paper, calculator, pencil case, mobile
phone or any other material/item which has not been authorised for the exam or specifically permitted as noted
below. Any material or item on your desk, chair or person will be deemed to be in your possession. You are
reminded that possession of unauthorised materials in an exam is a disciplinable offence under Monash Statute
4.1.

AUTHORISED MATERIALS

CALCULATORS YES NO
(Only calculators with an approved for use Faculty label can be used)

OPEN BOOK YES NO

SPECIFICALLY PERMITTED ITEMS YES NO
if yes, items permitted are:

This paper consists of Eight (8) questions and Two (2) pages of formulae printed on a total of Seven (7) pages.

Students must attempt to answer ALL questions.

PLEASE CHECK THE PAPER BEFORE COMMENCING. THIS IS A FINAL PAPER.


STUDENT ID: ... DESK NUMBER: .


THIS EXAMINATION PAPER MUST BE INSERTED INTO THE ANSWER BOOK AT THE
COMPLETION OF THE PAPER. NO EXAMINATION PAPERS SHOULD BE REMOVED FROM
THE EXAMINATION ROOM



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AFC2140 CORPORATE FINANCE
AFC2140 Dr Hue Hwa Au Yong Page 2 of 7


Question 1

(a) Marine Corp. issued 10-year bonds three years ago with an annual coupon rate of 6
percent. If the current market rate is 8 percent, what is the current market price of this
bond? (Explain your answer.)

(b) Ocean Co. is a fast-growing information technology company. The firm projects a rapid
growth of 20 percent for the next two years, then a growth rate of 10% for the following
two years. After that, the firm expects a constant-growth rate of 8%. The firm expects to
pay its first dividend of $2.00 a year from now.

If the required rate of return on such shares is 15%, what is the current price of the share?

(c) Why is share valuation more difficult than bond valuation?
(3 + 5 + 2 = 10 marks)


Question 2

You are planning to start up a family pizza restaurant on Clayton Road and need to buy a
motorcycle for delivering orders. You have two models in mind. Model A costs $8,000 and is
expected to run for 6 years. Model B is more expensive, with a price of $13,000 and an expected
life of 10 years. The annual maintenance costs are $700 for model A and $600 for model B.
Assume that the required rate of return is 10 percent.

Required:

(a) Define mutually exclusive projects and discuss whether Model A and B can be regarded
as mutually exclusive projects.

(b) Which model should be purchased? Show all workings.
(2 + 8 = 10 marks)











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AFC2140 CORPORATE FINANCE
AFC2140 Dr Hue Hwa Au Yong Page 3 of 7


Question 3

The new products division of Elec Limited has put forward a proposal to management to
manufacture a new digital plasma television. This is an 8 year project, during the first 3 years it is
expected that demand will be modest but should increase considerably in the subsequent 5 years
of the products life. The companys finance department has made the following estimates of
expected cash flows for the project.

The initial outlay of $380,000 is required and a further $100,000 at the end of each year for 3
years. The required return for this project is 15%.

The finance manager believes that the probability of high demand for the plasma television
during the first 3 years in the market will be 0.7. If demand is high in the first 3 years the manager
believes there is a 0.8 probability that demand will remain high in the following 5 years. However
if demand is low, management believes that there is a 0.6 probability that it will remain low.
Projected annual cash inflows are provided in the following table:
High Demand Low Demand
Annual cash inflows for first 3 years $150,000 $80,000
Annual cash inflows for next 5 years $230,000 $120,000
Required: (All workings must be shown):
(a) Set out a decision tree for the new digital plasma television project. Label the tree
appropriately to include states of nature at each stage, all cash flows and probabilities.
(b) Use the NPV (net present value) method to determine if the project should be undertaken.
What is the value of the NPV for this project? Should the project proceed?
(5 + 10 = 15 marks)
Question 4

The following methods are used for project evaluation.
NPV ~ Net present value
IRR ~ Internal rate of return
PI ~ Profitability index (benefit-cost ratio)
ARR ~ Accounting rate of return

Required:
(a) Explain how each of these methods is used to evaluate projects.
(b) What are the advantages and disadvantages associated with each method?
(4 + 8 = 12 marks)

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Question 5

The expected return and standard deviation (risk) of two financial assets (A & B) and a
government bond are as follows:

Asset A Asset B Bond
Expected Return 10% 15% 5%
Risk 12% 18% 0

Jacob develops a portfolio comprised of 25% of Asset A and 75% of Asset B. The correlation
between returns from Asset A and B is 0.8.

(a) What is the expected return from the portfolio?

(b) What is the risk of the portfolio?

(c) What would happen to the risk of the portfolio if the correlation between returns from the
two assets decreased?

(d) What are the benefits of diversification if the assets are perfectly correlated?

(e) If returns from two assets are perfectly (positively) correlated, demonstrate algebraically
that the risk of a portfolio comprised of the two assets is simply the weighted average of
the risk levels of the component assets.

(f) An investor decides to construct a portfolio comprised of Asset B and the government
bond. What proportion of the portfolio would be comprised of Asset B if the risk of the
new portfolio is 12% p.a.?
(2 + 3 + 1 + 1 + 3 + 3 = 13 marks)

Question 6
Asset A has an expected return of 9.8% with a beta of 0.60 and Asset B has an expected return of
17% with a beta of 1.50. If the two assets are correctly priced on the Security Market Line:
Required:
(a) What is the risk-free rate of return? What is the return of the market portfolio? Specify the
Security Market Line (SML) Equation.
(b) What does the beta parameter in the Capital Asset Pricing Model measure?

(c) Compare and contrast the Capital Asset Pricing Model and the Arbitrage Pricing Model.
(6 + 2 + 5= 13 marks)
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Question 7

The total market value of Mel Co.s equity capital is currently $1,050,000. The Company has
100,000 equity shares on issue and has just paid a total annual dividend of $50,000. Mel Co.s
earnings per share is expected to grow at an annual rate of 10% for the foreseeable future, and its
earnings and dividends are expected to be almost perfectly correlated with one another. A
mixture of equity and debt capital funds the companys operations. Mel Co.s debt capital
comprises 5,000 irredeemable bonds (each originally issued with a $100 nominal value) paying
interest at the rate of 10% per year. The total market value of Mel Co.s bonds is currently
$550,000 (ex interest). Mel Co.s effective tax rate is 30%.

Required:

(a) Calculate Mel Co.s cost of equity capital using the dividend valuation model. Show all
workings.

(b) What would Mel Co.s before-tax cost of debt capital be if its bonds were currently
valued in the market at their nominal total worth? Briefly explain why this answer is not
currently the Companys before-tax cost of debt capital.

(c) Calculate Mel Co.s current before-tax cost of debt capital using the debt valuation model.
Show all workings.

(d) Calculate Mel Co.s after-tax cost of debt capital showing all workings. Briefly explain
what effect tax has on the Companys cost of debt capital, and why it has this effect.

(e) Calculate Mel Co.s after-tax weighted average cost of capital. Show all workings.

(f) What does your answer to (e) represent to both Mel Co.s and Mel Co.s capital
providers?
(4 + 2 + 2 + 3 + 4 + 2 = 17 marks)
Question 8

(a) Lintner (1965) found that firms are reluctant to make dividend changes that might have to
be reversed. Discuss the rationale for this behaviour.

(b) Two investors, one on a high marginal income tax rate, and the other on a low marginal
income tax rate are considering investing in two firms, A & B. Firm A maintains a high
dividend payout ratio, whilst Firm B maintains a low dividend payout ratio. Which firm
might each of the investors be attracted to for investment and why?
(5 + 5 = 10 Marks)
(Total = 100 marks)
END OF EXAMINATION

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AFC2140 CORPORATE FINANCE
AFC2140 Dr Hue Hwa Au Yong Page 6 of 7

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AFC2140 CORPORATE FINANCE
AFC2140 Dr Hue Hwa Au Yong Page 7 of 7


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