Full Corporate Finance Answer

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FULL Corporate Finance Answer
Corporate Governance&Ethics (Tunku Abdul Rahman University College)
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TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

FACULTY OF ACCOUNTING, FINANCE AND BUSINESS
BBMF2093 CORPORATE FINANCE
TUTORIAL 1 NATURE AND SCOPE OF FINANCIAL PLANNING.
1. State the financial goal of a corporation.
ANSWER- The financial goal of a corporation is maximizing shareholders’ wealth through

maximizing the share price ie capital gain.
2. Briefly discuss “Agency relationship”.
ANSWER:
The relationship between stockholders and the management is called the agency
relationship. This occurs when the shareholders as principals hire their managers (agents)
to act on their behalf. The possibility of conflicts of interest between them is termed as the
agency problem. 2 types of agency relationship, shareholders and managers, as well as
shareholders and creditors
3. Explain the conflict of interest between shareholders and managers.
ANSWER- There is conflict of interest between shareholders and managers of

corporation. Shareholders hire managers with the hope that managers work hard to
maximize shareholders’ wealth.
Managers are inclined to act on their own selfish interest. They want to increase personal
wealth, more leisure, luxurious offices, generous retirement plans etc
4. Explain how shareholders can reduce agency problems.
1. ANSWER- Generally there are two ways of seeking to optimise managerial

behaviour in order to encourage goal congruence between shareholders and managers.
One is to monitor the actions of management through independent auditing and
shadowing of senior managers (Direct intervention of shareholders)
1. . The second alternative is by offering managerial incentives such as executive
share option schemes and Managerial performance share
Other ways to overcome agency problem between shareholders and managers

2. Threat of firing
3. Threat of takeover
5. Describe the three factors that affect stock price.
ANSWER- the three factors are level of cash flow, timing of cash flow and risk of cash flow.
Level of cash flow – amount of cash flow, the higher the cash flow, the higher the stock
price

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Timing of cash flow- the faster the cash flow, the higher the stock price
The lower the risk of cash flow the higher is the stock price
6. Differentiate market price and intrinsic value of common stock.
ANSWER
Market price- it is the share price that is traded in the stock market. It is the stock price is
based on perceived by the investor base on possibly incorrect information ie risk and
return data
Intrinsic value- it is the estimated true value of the stock based on certain information
given ie risk and return data
7. Briefly explain overvalued stock and undervalued stock.
ANSWER:
If stock price and intrinsic values are different, overvalued or undervalued stock can
occurred
If stock price is greater than intrinsic value, then the stock is overvalued, supply will be
greater than demand, stock price will fall
If stock price is less than intrinsic value, then the stock is undervalued, demand will be
greater than supply, the stock price will rise.
8. Discuss the effects of stock price maximization to society.
ANSWER:
a. efficient, low-cost operations that produce high-quality goods and services at the
lowest possible cost.
b. the development of products and services that consumers want and need, so the
profit motive leads to new technology, to new products, and to new jobs.
c. efficient and courteous service, adequate stocks of merchandise , and well-located

business establishments--factors that are all necessary to make sales, which are
necessary for profits.
9. Describe the three social responsibilities of corporation.
ANSWER:
Social responsibilities of corporation
a. Provide a safe working environment
b. Avoid polluting the air and water
c. Produce safe products
10. “A lot of sales may generate huge profit but not plenty of cash flow”. Explain.

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ANSWER: a lot of sales does not mean plenty of cash flow because some of the sales are
credit sales. Calculation of profit is based on accrual basis.

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TUTORIAL 2 INVESTMENT APPRAISAL
1. Differentiate between independent project and mutually exclusive project.
ANSWER:
 Independent projects – if the cash flows of one is unaffected by the acceptance of the
other.(choose as many projects as you want as long as you have the fund and fulfill
capital budgeting criteria)
 Mutually exclusive projects – if the cash flows of one can be adversely impacted by the
acceptance of the other.(can only choose 1 project and normally the best one)
2. Briefly explain the steps in capital budgeting process.

ANSWER;
 Estimate CFs (inflows & outflows).
 Assess riskiness of CFs.
 Determine the appropriate cost of capital.
 Find NPV and/or IRR.
 Accept if NPV > 0 and/or IRR > WACC.
3. Binaan Teguh Berhad (BTB) has two potential projects, Project A and Project B. The forecasted
cash flows and relevant information of the two projects are given below.
The internal rate of return (IRR) of Project A and Project B are 12 percent per year and 15
percent per year respectively. Both projects require initial capital in year 0 and having cost of
capital of 5 percent per year.
(a) Determine the initial capital of both projects.

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Use IRR to determine the initial capital of both projects A and B as IRR is the rate
when NPV = RM 0
PROJECT A INITIAL CAPITAL CALCULATION
YEAR CASH FLOW PVIF 12% Discounted Cash

million Flow M
0 ? 1.0000 ?
1 50 0.8929 44.64
2 80 0.7972 63.78
3 80 0.7118 56.94
4 90 0.6355 57.20
NPV 0.00 M
INITIAL CAPITAL OF PROJECT A = 44.64+63.78+56.94+57.2= 222.56 M
YEAR CASH FLOW PVIF IRR=15% Discounted Cash Flow

million M
0 ? 1.0000 ?
1 60 0.8696 52.18
2 40 0.7561 30.24
3 40 0.6575 26.30
4 20 0.5718 11.44
NPV 0.00 M
INITIAL CAPITAL OF PROJECT B = 52.18+30.24+26.30+11.44= 120.16 M
(b) Assuming both projects are mutually exclusive, suggest a capital budgeting decision using
Net Present Value (NPV) criteria. Show workings.
ANSWER
PROJECT A NPV CALCULATION
YEAR CASH FLOW PVIF 5% Discounted Cash Flow
million M
0 -222.56 1.0000 -222.56
1 50 0.9524 47.62
2 80 0.9070 72.56
3 80 0.8638 69.11
4 90 0.8227 74.04
NPV 40.77 M
c) NPV (Project A)
NPV = (47.62 + 72.56 + 69.11 + 74.04) - 222.58
NPV = 263.33 – 222.58 = RM40.77M
PROJECT B NPV CALCULATION

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YEAR CASH FLOW PVIF 5% Discounted Cash Flow

million M
0 -120.16 1.0000 -120.16
1 60 0.9524 57.14
2 40 0.9070 36.28
3 40 0.8638 34.55
4 20 0.8227 16.45
NPV 24.26 M
NPV (Project B)
NPV = (57.14 + 36.28 + 34.55 + 16.45) - 120.16
NPV= 144.42 – 120.156 = RM24.26 M
BTB should chose Project A due to higher NPV, compared to project B
(c) Calculate the following capital budgeting criteria of both projects.
PROJECT A
(i) Payback period A
i. Payback period (Io = 222.56)
= 3 + (12.56/90)
= 3.14 years
(ii) Discount Payback Period
ii. Discount Payback Period A

= 3 + (33.27/74.04) = 3.45 years
Project B
i. Payback period (Io = 120.16)
2 + (20.16/40)
= 2.50 years
ii. Discount Payback Period

2 + (26.74/34.55) = 2.77 years
(d) Is your capital budgeting decision in (b) consistent with decision using IRR? Provide reasons.
Answer :Project B (IRR = 15%) > Project A (IRR = 12%)

Project A (NPV = RM40.750) > Project B (NPV = RM24.26)

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NPV SAYS CHOOSE PROJECT A
IRR SAYS CHOOSE PROJECT B
THERE IS CONFLICT BETWEEN NPV AND IRR
USE NPV AS THE BETTER CAPITAL BUDGETING TECHNIQUE CAUSE NPV

MAXIMIZE SHAREHOLDERS WEALTH
Result is inconsistent between IRR and NPV

The conflict is due to the different pattern of cash flows between the two projects in which,
Project A has lower cash flows in the beginning of the period and increasing towards the
end, while Project B has higher cash flows in the beginning of the period and decreasing
towards the end of the period.
(c) Determine the Modified Internal Rate of Return (MIRR) for PROJECT A ONLY.
MODIFIED INTERNAL RATE OF RETURN FOR PROJECT A
YEAR CASHFLOW COMP CASHFLOW COMPOUNDED CF

YR 0 -222.5
YR 1 50 1.1576 57.88
YR 2 80 1.1025 88.20
YR 3 80 1.0500 84.00
YR 4 90 1.0000 90.00
TERMINAL VALUE 320.08
222.5 = 320.08/ (1+MIRR)4

MIRR= (320.08/222.56) I/4- 1 = 9.52%
MIRR = 9.52%
4. Why manager prefers the use of Modified Internal Rate of Return (MIRR) over IRR?
 MIRR assumes reinvestment at the opportunity cost = WACC. MIRR also avoids
the multiple IRR problem.
 Managers like rate of return comparisons, and MIRR is better for this than IRR.
5. The management of NuRobotic Sdn. Bhd. is considering to purchase a new equipment. Its
choice is between Equipment A and Equipment B. Both equipments have five-year useful life
and they are mutually exclusive.
The initial cost (cash outlay) for Equipment A is RM160,000 and for Equipment B is RM220,000
and their respective scrap values at the end of year 5 are given as follows:
Equipment A Equipment B
Initial Investment RM160,000 RM220,000
Scrap Value RM10,000 RM25,000
The cash inflows generated are as follows:

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Year Equipment A (RM) Equipment B (RM)
1 30,000 70,000
2 40,000 70,000
3 80,000 60,000
4 60,000 60,000
5 60,000 50,000
Required
(a) NuRobotic’s current investment policy is to accept only investment that are recoverable
within 4.5 years. Calculate the discounted payback period for equipment A and equipment B
if the cost of capital is 12%. Advise the company which new equipment to purchase if they
are mutually exclusive.
(b) Calculate the Net Present Value (NPV) for equipment A and equipment B given the cost of
capital is 12%.
(c) Advise the management on which equipment to purchase based on NPV calculation if
equipment A and equipment B are mutually exclusive. Explain your recommendation.
(d) The simple payback method of investment appraisal is the most popular method used in
practice. However, it has several theoretical limitations. Discuss the FOUR (4) limitations of
this capital budgeting technique.
ANSWER TO QUESTION 5 (PY 2016)
Required:
(e) NuRobotic’s current investment policy is to accept only investment that are recoverable within
4.5 years. Calculate the discounted payback period for equipment A and equipment B if the
cost of capital is 12%. Advise the company which new equipment to purchase if they are
mutually exclusive. (6 marks)
Net Present Value (RM)

Expected Net C/F Present Value
Year PVIF @12% Equip A Equip B Equip A Equip B
0 1.0000 (160,000) (220,000) (160,000) (220,000)
1 0.8929 30,000 70,000 26,787 62,503
2 0.7972 40,000 70,000 31,888 55,804
3 0.7118 80,000 60,000 56,944 42,708
4 0.6355 60,000 60,000 38,130 38,130
5 0.5674 60,000 50,000 34,044 28,370
5 0.5674 10,000 25,000 5,674 14,185
Discounted payback for equipment A = 4 years + 6252/34044= 4.18 years
Discounted payback for equipment B = 4 years + 20855/28370= 4.74 years

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The company should select equipment A because it has shorter discounted payback
period..
(f) Calculate the Net Present Value (NPV) for equipment A and equipment B given the cost of
capital is 12%. (6 marks)
Net Present Value (RM)

Expected Net C/F Present Value
Year PVIF @12% Equip A Equip B Equip A Equipment B
0 1.0000 (160,000) (220,000) (160,000) (220,000)
1 0.8929 30,000 70,000 26,787 62,503
2 0.7972 40,000 70,000 31,888 55,804
3 0.7118 80,000 60,000 56,944 42,708
4 0.6355 60,000 60,000 38,130 38,130
5 0.5674 60,000 50,000 34,044 28,370
5 0.5674 10,000 25,000 5,674 14,185
33,467√ 21,700√
(g) Advise the management on which equipment to purchase based on NPV calculation if
equipment A and equipment B are mutually exclusive. Explain your recommendation.
Both equipment A and B has positive NPV values. The management should select
equipment A because equipment A has the higher NPV value than equipment B given
both of them are mutually exclusive. A higher positive NPV value would help to maximize
the shareholders’ wealth .
(4 marks)
(h) The simple payback method of investment appraisal is the most popular method used in
practice. However, it has several theoretical limitations. Discuss the FOUR (4) limitations of
this capital budgeting technique. (4 marks)
ANSWER
Limitations of Payback Period:
 It does not consider the entire life of the investment project.

 It does not consider the riskiness of the cash flow.
 It is a measure of liquidity not profitability.
 It does not consider the timing of the cash flow.
6. Healthy Food Inc. is considering switching its manually operated machine with a new automated
machine. Although the existing unit has 5 more years of service life, its operating costs are fairly
high compared to its revenue. The new automated machine costs RM2.5 million. An additional

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RM100,000 is needed for transportation and installation. The new machine is expected to
generate incremental revenues of RM2 million with an incremental overhead cost of RM700,000
per year. It will be depreciated over 5 years to a salvage value of RM200,000.
(a) If the firm’s cost of capital is 12%, calculate the following:
(i) Payback period
Total cost / total cash outflow = RM 2.5 million + RM100,000=RM 2.5 m + 0.1m= RM2.6 m
Net cash inflow = RM2.0m -0.7m = RM 1.3m
ANS- RM2.6million/RM1.3million = 2 years
(ii) Net Present value, NPV
ANS:
NPV = Total Cash Inflow (PV) – Total Cash Outflow

= RM1.3million (PVIFA 12%,4) + RM1.5million (PVIF 12%, 5) – RM2.6million
= RM1.3million (3.0373) + RM1.5million (0.5674) – RM2.6million
= RM2.2 million

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TUTORIAL 3 INTRODUCTION TO RISK
1. Jerome J. Jerome is considering investing in a security that has the following distribution of
possible one-year returns:
Probability of 0.1 0.2 0.3 0.3 0.1

occurrence
Possible return -0.1 0.0 0.1 0.2 0.3
(a) What is the expected return and standard deviation associated with the investment?
EXPECTED RETURN IS 0.11

STANDARD DEVIATION IS 11.36 %
2. Describe market risk and diversifiable risk.
ANSWER
Market risk / systematic risk/ non-diversifiable risk
 Interest rate risk, the chance that changes in interest rates will adversely affect
the value of an investment
 Liquidity risk, the chance that an investment can’t be easily liquidated at a
reasonable price
 Market risk, the chance that the value of an investment will decline because of
market factors that are independent of the investment
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 Inflation risk, political risk, reinvestment risk
Diversifiable risk/Non-systematic risk/ Firm-specific risk/ Business risk, the chance that the
firm will be unable to cover its operating costs
 Financial risk, the chance that the firm will be unable to cover its financial
obligations, risk associate with debt financing
 Business risk – the chance that the business will not be able to cover business
operating cost/ expense.
3. Briefly explain variance and standard deviation.
Both variance and standard deviation can be used to measured risk of an asset
Variance is a measure of dispersion of an asset . it is the average value of squared deviation from a
mean.
Given an asset's expected return, its variance can be calculated using the following equation:
N
2
Var(R) = s = S pi(Ri – E[R])2
i=1
• Where:
– N = the number of states
– pi = the probability of state i
– Ri = the return on the stock in state i
– E[R] = the expected return on the stock
–
Standard deviation is the square root of variance. Standard deviation is an indicator of risk
of that asset‘s expected return, which measure the dispersion around its expected value.
Standard deviation measure the total risk of an asset. The larger the SD, the lower the
probability the actual return will be closer to expected return. The larger the SD, the larger
risk.
Standard deviation is indicator of risk asset (an absolute measure of risk) of that asset’s expected
return, σ (Ri), which measures the dispersion around its expected value. This can be calculated using
equation below:
σ (Ri) = √  [R j - E(Ri) ]2 x Pr j
4. What is coefficient of variation?
Coefficient of variation is risk per unit return.

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Coefficient of Variation is a statistical measurement of relative dispersion of an asset
return. It is useful in comparing the risk of assets with differing average or expected
return.
Formula for CV is:
Coefficient of Variation = Standard Deviation

Average or Expected Return
CV = σ (Ri)
E(Ri)
5. What is the difference between realized rate of return and required rate of return?
Realized Rate of Return

The return that is actually earned over a given time period.
Required Rate of Return

The minimum rate of return necessary to compensate an investor for accepting the
risk the investor associates with the purchase & ownership of an asset
6. Stock X has a 9% expected return, a beta coefficient of 0.8 and a 30% standard deviation of
expected returns. Stock Y has 14% expected return, a beta coefficient of 1.3 and a 20% standard
deviation. The risk free rate is 5% and market risk premium is 6.5%.
ANSWER :
a. calculate the coefficient of variation of each stock
Coefficient variation = standard deviation / expected return

Coefficient of variation for stock X = 30% /9% = 3.3333
Coefficient of variation for stock Y= 20%/14% = 1.43
b. which stock is riskier than the other stock?
Stock X is riskier than stock Y because Coefficient of variation CV of X is higher than CV

of Y. stock X has a higher risk per unit return
c. what is the required return of each stock?
REQUIRED RETURN= RISK FREE RETURN + RISK PREMIUM X BETA (CAPM)

required return for stock X = 5% + 0.8 (6.5%) = 10.2%
required return for stock Y= 5% + 1.3 ( 6.5%)= 13.45%

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7. A stock’s returns have the following distribution
Demand for company product probability of this demand rate of return
Weak 10% (50%)

Below average 20% (5%)
Average 40% 16%
Above average 20% 25%
Strong 10% 60%
_____
100%
Calculate the stock’s expected return, standard deviation and coefficient of variation
Expected return for stock is
ER=0.1 x (-50%) + 0.2 x(-5%) + (0.4 x 16%) + 0.2 x 25% + 0.1 x 60% = -5 %+ (-1%) + 6.4%
+5% + 6% = 11.4%
variance = (-50%-11.4%)2 x 0.1 + (-5%-11.4%) 2 x 0.2 +

(16%-11.4%)2 x 0.4 + (25%-11.4%)2 x 0.2 + (60%-11.4%)2 x 0.1
= (-61.4%)2 x 0.1 + (-16.4%)2 X0.2 +( 4.6%)2 x 0.4 + (13.6%)2 x0.2 +(48.6%)2 x0.1
= 376.99 %2 + 53.79%2 + 8.46%2+ 36.99%2 + 236.19% 2
= 712.42%2
Standard deviation = √ (712.42%2)= 26.69%
Coefficient of variation = 26.69%/ 11.4% = 2.34
8. Samson, the financial manager for A2A Corporation, wishes to evaluate three prospective
investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk
index of 6%. The expected return and expected risk of the investments are as follows:
Investment Expected Return Expected Risk

X 14% 7%
Y 12% 8%
Z 10% 9%
(a) If Samson were risk-indifferent, which investments would he select? Explain why.
(b) If he were risk-averse, which investments would he select? Why?
(c) If he were risk-seeking, which investments would he select? Why?
(d) Given the traditional risk preference behavior exhibited by financial managers, which
investment would be preferred? Why?

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(a) The risk-indifferent manager would accept Investments X and Y because these have higher returns
than the 12% required return and the risk doesn’t matter.
(b) The risk-averse manager would accept Investment X because it provides the highest return and has
the lowest amount of risk. Investment X offers an increase in return for taking on more risk than
what the firm currently earns.
(c) The risk-seeking manager would accept Investments Y and Z because he or she is willing to take
greater risk without an increase in return.
(d) Traditionally, financial managers are risk averse and would choose Investment X, since it provides
the required increase in return for an increase in risk

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TUTORIAL 4 PORTFOLIO THEORY
1. Selene Maranjian invests the following sums of money in common stocks having expected
returns as follows:
COMMON STOCK AMOUNT INVESTED EXPECTED RETUN

(TICKER SYMBOL)
One-Legged Chair Company (WOOPS) $6,000 0.14
Acme Explosives Company (KBOOM) $11,000 0.16
Ames-to-Please, Inc. (JUDY) $9,000 0.17
Sisyphus Transport Corporation $7,000 0.13
(UPDWN)
Excelsior Hair Growth, Inc. (SPROUT) $5,000 0.20
In-Your-Face Telemarketing, Inc. $13,000 0.15
(RINGG)
McDonald Farms, Ltd. (EIEIO) $9,000 0.18
(a) What is the expected return (percentage) on her portfolio?

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(b) What would be her expected return if she quadrupled her investment in Excelsior Hair
Growth, Inc., while leaving everything else the same?
2. Colours Plc. is considering two mutually exclusive investments: Black and White. The possible
net present values for both projects and the associated probabilities are as follows:
(a) Determine the levels of risk of each investment project.

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(b) Assuming, the management is risk averse, justify the investment it should accept.
Colours plc should accept project Black because it has a lower level of risk
Alternatively, the firm has an opportunity to invest in two overseas locations for a planned
expansion of its production facilities. The future returns from the investments depend to a large
extent on the economic situation of the countries under consideration. An analysis of the expected
rates of return under three different scenarios is as follows:
(c) What would be the expected return and standard deviation of the portfolio if the available
funds were split 60% to Region 1 and 40% to Region 2?
Expected return from region 1 ER1= 0.3x 30 \% + 0.4x25% + 0.3 x 20% = 9%+10%+6%=25%
Expected return form region 2 ER2= 0.2 x50%+ 0.6 x 30%+0.2x 10%= 10%+18%+2%=30%

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Portfolio expected return = E[Rp] = w1E[R1] + w2E[R2]
w1= 0.6, w2=0.4, ER1= 25% , ER2= 30%

Expected portfolio return = 0.60 x 25% + 0.40 x 30%= 27%
SD1= √ (30%-25%)2X0.3 + (25%-25%)2 X 0.4 + (20%-25%)2 X 0.3 = 3.87%

SD2 = √ (50%-30%)2X0.2 + (30%-30%)2 X 0.6 + (10%-30%)2 X 0.2 = 12.6%
W1=0.6, W2=0.4 , ER1=25%, ER2= 30% SD1= 3.87%, SD2= 12.6% , CC = 1
PORTFOLIO RISK SDp = √(wA)2s2A + (wB)2s2B + 2wAwBrA,B sAsB

Portfolio standard deviation = √ [0.62x (3.87%)2 +0.42(12.6%)2 +2 x 0.6 x0.4 x 3.87%x12.6%x1]
Expected portfolio risk = 7.34%
(d) Should the firm consider expanding operations in both the regions? Justify.
In this case, it is advisable for Colours to diversify its investment into both the regions, as
marginal reduction in risk is still higher than the marginal reduction in expected return.

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3. The Investment Department of Meakom Bhd has been allocated a fixed capital sum by the Board
of Directors for its capital investments for next year. The department’s manager has identified
three viable capital projects which could enhance the wealth of its shareholders. However, the
funds allocated are sufficient for only two of the capital projects, which are not divisible and
cannot be postponed to a later date. Each project requires the same amount of investment.
The manager proposes to use portfolio theory to determine which two projects should be
undertaken, based upon an analysis of each project’s as well as the portfolio risk and return.
The investment department has collected the following data:
The expected return of Project B = 8.6%

The expected return of Project C = 14.2%
The standard deviation of Project B =7%
The standard deviation of Project C =9%
The covariance between projects A and B =26.42%
The possible investment options are as follows:
Required:
(a) Calculate the expected return and the standard deviation of Project A.
(b) Calculate the expected return (i) and standard deviation (ii) of a portfolio consisting of 60%
of investment in Project A and the remainder in Project B.
(c) Recommend the combination of the investments that the company should choose.

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Standard deviation of portfolio A&B = √0.62 (0.08)2 +0.42(0.07)2+2x0.6x0.4x0.2642=

0.3604=36.04%

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4. Explain covariance and correlation coefficient.
Covariance is a measure that combines the variance of a stock’s returns with the tendency
of those returns to move up or down at the same time other stocks move up or down.
Since it is difficult to interpret the magnitude of the covariance terms, a related statistic,
the correlation coefficient, is often used to measure the degree of co-movement between two
variables. The correlation coefficient simply standardizes the covariance.

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TUTORIAL 5 CAPITAL ASSET PRICING MODEL- C.A.P.M
1. Assuming that the CAPM approach is appropriate, compute the required rate of return for each
of the following stocks, given a risk-free rate of 0.07 and an expected return for the market
portfolio of 0.13:
Stock A B C D E
Beta 1.5 1.0 0.6 2.0 1.3
What implications can you draw?
Required return . (Rj) = Rf + [E(Rm) – Rf] Betaj
Req. (RA) = 0.07 + (0.13 – 0.07) (1.5) = 0.16 =16%

Req. (RB) = 0.07 + (0.13 – 0.07) (1.0) = 0.13 =13%
Req. (RC) = 0.07 + (0.13 – 0.07) (0.6) = 0.106 =10.6%
Req. (RD) = 0.07 + (0.13 – 0.07) (2.0) = 0.19 = 19%
Req. (RE) = 0.07 + (0.13 – 0.07) (1.3) = 0.148 =14.8%
The relationship between required return and beta should be stressed.
STOCK WITH HIGHER BETA WILL HAVE HIGHER RETURN EG STOCK D,

BETA=2, AND REQUIRED RETURN IS 19%, STOCK B HAS BETA =1. RETURN =
13%
2. On the basis of an analysis of past returns and of inflationary expectations, Marta Gomez feels
that the expected return on stocks in general is 12%. The risk-free rate on short-term Treasury
securities is now 7%. Gomez is particularly interested in the return prospects for Kessler
Electronics Corporation. Based on monthly data for the past five years, she has fitted a
characteristic line(SML) to the responsiveness of excess returns of the stock to excess returns of
the S&P500 Index and has found the slope of the line to be 1.67. If financial markets are
believed to be efficient, what return can she expect from investing in Kessler Electronics
Corporation?
ANSWER
BASED ON CAPM,
Required return = 0.07 + (0.12 – 0.07)(1.67) = 0.1538, or 15.38%

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3. Currently, the risk-free rate is 10% and the expected return on the market portfolio is 15%.
Market analysts’ return expectations for four stocks are listed here, together with each stock’s
expected beta.
STOCK EXPECTED RETURN EXPECTED BETA
1. Stillman Zinc Corporation 17.0% 1.3

2. Union Paint Company 14.5% 0.8
3. National Automobile Company 15.5% 1.1
4. Parker Electronics, Inc. 18.0% 1.7
(a) If the analysts’ expectations are correct, which stocks (if an) are overvalued? Which (if any) are
undervalued?
REQUIRED RETURN= Required return . (Rj) = Rf + [E(Rm) – Rf] Betaj
STOCK EXPECTED RTN,ER REQUIRED RTN (SML)
STOCK 1 17.0% 10%+(15%-10%)x1.3=16.3% UNDERVALUED

ER above SML line
STOCK 2 14.5% 10%+(15%-10%)x0.8=14.0% UNDERVALUED

ER above SML line
STOCK 3 15.5% 10%+(15%-10%)x1.1=15.5% NEUTRAL
STOCK 4 18.0% 10%+(15%-10%)x1.7=18.5% OVERVALUED

ER below SML line
Expected return > required return  undervalue
Expected return < required return  overvalue
The (a) panel, for a 10% risk-free rate and a 15% market return, indicates that stocks 1 and
2 are undervalued while stock 4 is overvalued. Stock 3 is priced so that its expected return
exactly equals the return required by the market; it is neither overpriced nor underpriced.

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(b) If the risk-free rate were suddenly to rise to 12% and the expected return on the market
portfolio to 16%, which stocks (if any) would be overvalued? Which (if any) undervalued? (Assume
that the market analysts’ return and beta expectations for our four stocks stay the same.)
STOCK EXPECTED REQUIRED RETURN ( ALL OVERVALUED OR

RETURN , ER VALUES ON SML LINE) UNDERVALUED
STOCK 1 17.0% 12%+(16%-12%)x1.3=17.2% OVERVALUED-

ER below SML line
The (b) panel, for a 12% risk-free rate and a 16% market return, shows all of the stocks
overvalued. It is important to stress that the relationships are expected ones. Also, with a
change in the risk-free rate, the betas are likely to change.

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4. Salt Lake City Services, Inc., provides maintenance services for commercial buildings.
Currently, the beta on its common stock is 1.08. The risk-free rate is now 10%, and the expected
return on the market portfolio is 15%. It is January 1, and the company is expected to pay a RM2
per share dividend at the end of the year, and the dividend is expected to grow at a compound
annual rate of 11% for many years to come. Based on the CAPM and other assumptions you
might make; what dollar value would you place on one share of this common stock?
Required return ke =10% +(15%-10%)X1.08= 0.10 + (0.15 – .10)(1.08)

= 0.10 + .054 = 0.154 or 15.4 %
Ke= 15.4 %, g=11% , D1=RM 2
Assuming that the perpetual dividend growth model is appropriate, we get

V = D1/(ke – g) = RM2/(0.154 –0.11) = RM2/0.044 = RM 45.45
5. The finance director of Bentras plc wishes to find the company's optimal capital structure. The
cost of debt varies according to the company's credit rating, which itself depends, amongst other
factors, upon the level of gearing of the company.
The company's ungeared equity beta (asset beta) is 0.85. The risk free rate is 6% per annum, and
the market return 14% per annum. Corporate taxation is at the rate of 30% per year.
Estimate the company's cost of equity using C.A.P.M (Assuming the company is ungeared).
ANSWER :
Assuming all market risk is borne by equity holders (i.e. the beta of debt is zero), the
relationship between the beta of geared and ungeared equity is :
Using CAPM, Ke= Rf + (Rm-Rf) beta
With 100 % equity or ungeared, the cost of equity is
Ke= 6% + (14% - 6%) x 0.85 = 12.8%

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6. Mr. Rich owns a portfolio consisting shares of five public listed firms. The details of these
securities and his asset allocation are provided below:
The market return is 15% and risk-free investments offer 7%.
(a) Calculate the required rate of return for each security in Mr. Rich’s portfolio, using the
Capital Asset Pricing Model.
(b) Determine the portfolio beta. Is this portfolio riskier than the market? Justify.

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Rf= 0.07
Rm – Rf = 0.15-0.07= 0.08 market ridsk premium
Beta = 0.75
Total value of 5 stocks = 22k+45K+33K+24k+52k=176000
Portfolio beta is the weighted average of individual beta

Weight is the percentage of fund invested in each of the stock
The portfolio beta of 1.0 reflects a beta coefficient of the market. No ,the portfolio is not riskier than
the market. This portfolio now carries as much systematic risk as the stock market. Mr. Rich has
managed to reduce the systematic risk of his investment portfolio through his allocations
diversification.

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7. Why is beta a measure of systematic risk? What is its meaning?
Beta measures the responsiveness of changes in excess returns for the security
involved to changes in excess returns for the market portfolio. It tells us how
attuned fluctuations in returns for the stock are with those for the market. A
beta of one indicates proportional fluctuation and systematic risk; a beta
greater than one indicates more than proportional fluctuation compare to
market; and a beta less than one indicates less than proportional fluctuation
relative to the market.
8. What is the required rate of return of a stock? How can it be measured?
Required return is the minimum return investor needs to invest in a stock
By CAPM,
Required returned. (Rj) = required rate of return for security j;

Rf = risk-free rate;
E(Rm) = expected rate of return for the market portfolio;
Betaj = beta for security j.
9. Differentiate expected rate of return and required rate of return.
ANSWER
Expected Rate of Return
a. The expected benefits/returns to be received from an investment come in the form of
the cash flows the investment generates. The most likely return on a given asset
Required Rate of Return
b. The minimum rate necessary to compensate an investor for accepting the risk the
investor associates with the purchase & ownership of an asset
10. Suppose that you are highly risk averse but that you still invest in common stocks. Will the
betas of the stock in which you invest be more or less than 1.0? Why?
ANSWER
If you limit yourself to only common stock, you would seek out defensive stocks -- where
returns tend to go up and down by less than those for the overall market. Therefore, the
betas would be less than 1.0.
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11. If a security or stock is undervalued in terms of the capital-asset pricing model, what will
happen if investors come to recognize this undervaluation?
ANSWER
The undervalued stock would lie above the security market line, thereby
providing investors with more expected return than required for the
systematic risk involved. Investors would buy the stock and cause it to rise
in price. The higher price will result in a lower expected return.
Equilibrium is achieved when the expected return lies along the security
market line.
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TUTORIAL 6 SOURCES OF FINANCE
1. Explain any TWO (2) sources of corporate financing.
ANSWER- Two main sources of corporate financing is equity financing and debt financing.
Examples of equity financing is issuance of new common shares and preference shares.
Term loan, debentures and bond issuance are examples of debt financing.
Shareholders are the owners of the firm in which they are entitled to dividend if firms
generate profit. Bondholders are creditors to a firm. They receive fixed coupon payment
(annually or semi-annually) until maturity of the bond plus principal at maturity.
2. Explain the following terms:
a. Treasury stock
Treasury stock – stocks that have been repurchased by the company and
held in treasury. Treasury stocks are not used in calculating outstanding
stock.
b. Callable bond
Callable bond –bond that may be repurchased by a firm before maturity at

specified call price.
c. Default risk
Default risk- the likelihood that the firm will walk way from its obligation, that is
not paying interest obligation and principal upon maturity.
d. Warrant
Warrant – it is a right to buy a certain amount of shares from a company at a

specified price at a stipulated time in the future .
e. Convertible bond
Convertible bond- bondholders can convert the bond into shares at a certain
price for a specific amount in the future .
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3. Explain operating lease and finance lease.
Operation lease – it is also called service lease. The lessor maintain and service the asset.
Short term lease that can be cancelled at the option of the lessee. Not
fully amortized. Rental payments do not fully cover the cost of asset.
Finance lease – financing of asset is involved. It involved a third party who is the supplier
of asset. Lessor does not provide for maintenance and servicing. Long term
lease that is not cancellable. It is fully amortized. Rental payments can
fully cover the cost of asset plus a return on investment.
4. What is an option?
Option – an option gives its holder the right but not the obligation to buy or sell an asset at
some predetermined price at a specified time in the future.
5. Warrant is a long term call option. Explain.
Warrant is a call option because a warrant gives the holder the right to buy a fixed
number of common shares at a predetermined price during a specified time period, usually
several years.
6. Differentiate between book value and market value of common stock.
Book value of common stock is based balance sheet. Historical value

Market value is the current stock price of common stock.
7. What is right issues? Explain “ 1 for 6 “ right issue offer.
Right issue is selling new shares to existing shareholders of the company. It is one way for
the company to raise equity financing. 1 for 6 means for every 6 shares held, the investor is
entitled to 1 right issue share.
8. What is the relationship between bond price and interest rate?
As interest rate increases , bond prices falls or vice versa. As interest rate increases, the
bond needs to be sold at a discount(less than $1000). As interest rate decreases, the bond
will be sold at a premium(more than $1000).
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9. Briefly explain debenture as a form of corporate debt.
Debenture is a secured bond because it is secured on specific asset of the company. That is it
provides specific collateral for the bond.
10. Explain how the use of restrictive covenant can protect the interest of bondholders.
A restrictive covenant or protective covenant is a restriction on the firm to protect the

bondholders. Eg bondholders can restrict company from issuing further debt to protect the
bondholders.
11. Describe the potential benefits of leasing as compare to debt financing
The potential benefits of leasing are
a. Reduce risk of obsolescene of asset

b. 100% financing
c. Conservation of working capital ie minimal capital outlay
d. Ease of obtaining credit
e. Convenience and flexibility ie faster and easier to obtain approval
12. Preferred stock is also known as hybrid security. Explain.
Preferred stock is known as hybrid security because it has both equity and debt
characteristics
Preferred stock is like equity because preferred stock has no maturity date and preferred
stock will be paid only after debtholders are fully paid in times of liquidation
Preferred is like debt because preferred stock has fixed dividend payment which is fixed
income just like debt.
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TUTORIAL 7 COST OF FUNDS
1. Briefly describe the two major decisions made by financial managers i.e. capital budgeting
decision and financing decision.
Capital budgeting decision refers to how much to invest and which real assets to invest
inusing capital budgeting technique such as NPV, IRR, PAYBACK ETC, and financing
decision refers to how to raise the necessary cash using debt financing or equity financing.
2. Describe the three steps used to calculate cost of capital.
The steps in calculating cost of capital are

a. Calculate the value of each security or asset as a proportion of the firm’s market value
b. Determine the required rate of return of security
c. Calculate the average after tax return on the debt and the return on the equity
3. Retained earnings have a cost. Explain.
Retained earning has a cost because retained earning has opportunity cost.
Earning can be either reinvested or paid out as dividend. The investors could use the
dividend to buy other securities and earn a return. If earning are retained, there is an
opportunity cost ie the return that stockholders could earn on an alternative investment.
4. The Sprouts-N-Steel Company (SNS) has two divisions: health foods and specialty metals. Each
division employs debt equal to 30% and preferred stock equal to 10% of its total requirements,
with equity capital used for the remainder. The current borrowing rate is 15%, and the company’s
tax rate is 40%. At present, preferred stock can be sold yielding 13%.
SNS wishes to establish a minimum return standard for each division based on the risk of that
division. This standard then would serve as the transfer price of capital to the division. The
company has thought about using the capital-asset pricing model in this regard. It has identified
two samples of companies, with modal value betas of 0.9 for health foods and 1.3 for specialty
metals. (Assume that the sample companies had similar capital structures to that of SNS.) The
risk-free rate is currently 12% and the expected return on the market portfolio 17%. Using the
CAPM approach, what weighted average required returns on investment would you recommend
for these two divisions?
AFTER TAX Cost of debt = 15%(1 – 0.4) = 9% {Rd(1-t)}
Cost of preferred stock = 13% Rp
Cost of equity for Health Foods division

= 0.12 + (0.17 – 0.12) 0.90 = 16.5% Rc for health food
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Cost of equity for Specialty Metals division

= 0.12 + (0.17 – 0.12) 1.30 = 18.5% Rc for sp. metals
Weighted-average required return for Health Foods division

= 9% (0.3) + 13%(0.1) + 16.5% (0.6) = 13.9%
Weighted average required return for Specialty Metals division

= 9% (0.3) + 13%(0.1) + 18.5% (0.6) = 15.1%
5. Zapata Enterprises is financed by two sources of funds: bonds and common stock. The cost of
capital for funds provided by bonds is k i, and ke is the cost of capital for equity funds. The capital
structure consists of B dollars worth of bonds and S dollars’ worth of stock, where the amounts
represent market values. Compute the overall weighted average of cost of capital, k0.
6. Assume that B (in Question 5) is RM3 million and S is RM7 million. The bonds have a 14% yield
to maturity, and the stock is expected to pay RM500,000 in dividends this year. The growth rate
of dividends has been 11% and is expected to continue at the same rate. Find the cost of capital if
the corporation tax rate on income is 40%.
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7. Tanjung Murni’s balance sheet dated 31-12-20X7 shows the following details on its capital
structure component.
Capital Structure Component Book Value (RM’000)
Long Term Debt (Bond) 1,200
Preferred Stock 800
Common Equity 2,000
Additional information
 The company’s common stock currently trades for RM55 per share
 The common stock’s last year dividend was RM2.10 per share
 The common stock dividend growth rate = 9% per year
 A floatation cost of 10% would be required to issue new common stock
 The company’s preferred stock pays a dividend of RM3.30 per share
 Price of preferred stock = RM100 per share
 Cost of debt (before tax cost) = 10%, Corporate tax = 35%
 Market return = 12%, risk free rate = 6%, stock beta = 1.60
(a) Calculate the cost of each capital component
(i) Long term debt (after tax cost)
(ii) Preferred stock
(iii) Equity from retained earnings (Use Dividend Discount Model)
(iv) Equity from retained earnings (Use CAPM)
(v) Newly issued common stock (Use Dividend Discount Model)
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(b) Determine the weighted average cost of capital (WACC) of the company if it must issue new
common stock for its expansion.
(c) What appears to have had happened to interest rates assuming market value of the company’s
capital component records the following values as of 31-10-2008, long term debt =
RM1,480,000, preferred stock = RM880,000 and common equity = RM3,200,000.
8. What are the factors that influence a company’s composite cost of capital?
The factors that could influence a company’s cost of capital
Market conditions such as interest rate and tax rates which the firm cannot control.
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Second is the capital structure and dividend policy, investment policy which the firm can
control.
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TUTORIAL 8 & 9 CAPITAL STRUCTURE / DIVIDEND POLICY
1. Explain the differences between business risk and financial risk.
Business risk ,- the uncertainty about the future operating income, example uncertainty
about sales, uncertainty about output prices, uncertainty about cost,
product and operating leverage
Financial risk, - financial risk is an increase in stockholder’s risk above business risk
resulting from the use of financial leverage. i.e. the use of debt n preferred
stock
2. What is operating leverage? Explain how operating leverage can affect a firm’s business risk.
Operating leverage is the use of fixed cost (automation) rather than variable cost. If the
firm has high operating leverage, a drop in sales will affect the business risk of the firm.
3. Explain financial leverage.
Financial leverage is the use of debt/bond and preferred stock in capital structure, debt has
fixed interest payment and principal payment which are fixed commitment, default in
interest payment and principal payment can lead to bankruptcy proceeding.
4. What is the effect of financial leverage on financial risk?
Financial leverage will concentrate the additional risk on the shareholders ie financial
leverage increase the risk of bankruptcy which is borne by the common shareholders. The
shareholders the residual owner in times of liquation.
5. Explain optimal capital structure.
Optimal capital structure is the mix of debt, preferred stock and common equity at which
share price is maximized.
6. Explain Hamada equation.
Hamada equation is used to change unleveraged beta to leverage beta.
bL = bU[1 + (1 – T)(D/E)]
bL = leveraged beta, beta of a company share with debt

bU = unleveraged beta, beta of a company share with no debt
T= corporate tax rate
(D/E)= debt /equity ratio
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7. A relatively young firm has capital components valued at book and market and market component
costs as follows. No new securities have been issued since the firm was originally capitalized.
(a) Calculate the firm's capital structures (weight) and WACCs based on both book and market
values, and compare the two.
(b) What appears to have happened to interest rates since the company was started?
(c) Does the firm seem to be successful? Why?
(d) What would be the implication of using a WACC based on book as opposed to market values
in investment appraisal ? In other words, what kinds of mistakes might management make by
using the book values WACC?
Comparison: The overall cost of capital has risen due to the net impact of a large increase in the
value of the firm's equity. This throws more of equity's high cost into the WACC.
b. Interest rates appear to have fallen, since the market values of debt and preferred exceed their
original values.
c. The firm seems to be successful because of the substantial increase in the value of equity.
This could be due to an increase in stock price or a rapid accumulation of retained earnings or a
combination of both.
d. Using the book based WACC might lead to accepting projects that wouldn't achieve the
expectations investors have for the company's return.
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e. Eg IRR =16%, WACC BASED ON BV= 15.3% ACCEPT PROJECT WRONG
DECISION
IRR =16%, WACC BASED ON MV= 17.9% REJECT PROJECT RIGHT DECISION
8. Briefly explain the three theories as they relate to dividend policy.
The three theories are

 Modigliani and Miller irrelevance theory – dividends are irrelevant, investors do
not care about dividend payout. Dividend is not important in determining the stock
price, stock price depends on operating cash flow not dividend
 Bird in the hand theory – investors prefer a high dividend payout. High dividend is
more important than future capital gain. High dividend will result in higher stock
price
 Tax preference theory – investors prefer a low dividend payout, hence future firm’s
growth ie future capital gain Besides that, Capital gain tax is deferred. Low
dividend, higher stock price in the future.
9. Tijuana Brass Instruments Company treats dividends as a residual decision. It expects to generate
$2 million in net earnings after taxes in the coming year. The company has an all-equity capital
structure, and its cost of equity capital is 15%. The company treats this cost as the opportunity
cost of “internal” equity financing (retained earnings). Because of flotation costs and
underpricing, “external” equity financing (new common stock) is not relied on until internal
equity financing is exhausted.
(a) How much in dividends (out of the $2 million in earnings) should be paid if the company has
$1.5 million in projects whose expected returns exceed 15%? RESIDUAL DIVIDEND
MODEL
Using residual dividend model

Company use 100% equity financing, all the $1.5 million will be financing by retained
earning
Equity /retaining earning financing= 100% x$ 1.5 million = $1.5 million
Residual dividend = earning – equity financing = $ 2.0 m- $1.5 m= $0.5 m= $500,000
Dividends = $500,000 DIVIDEND PAYOUT RATIO = 500,000/2,000,000= 25%
(b) How much in dividends should be paid if it has $2 million in projects whose expected returns
exceed 15%?
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Project is $ 2 million and is 100% equity financing ie 100% financed with retained
earning of $2m
Residual dividend = earning – equity financing for project = $2m - $2 m= $ 0 m
Dividends = $0 ZERO DIVIDEND PAYOUT
(c) How much in dividends should be paid if it has $3 million in projects whose expected returns
exceed 15%? What else should be done?
Project is $ 3 million and is 100% equity financing ie 100% financed with retained
earning of $2m
Residual dividend = earning – equity financing for project = $2m - $3 m= -$ 1.0 m
Dividends = $0 ZERO DIVIDEND PAYOUT
Dividends = $0. Company should raise an additional $1 million through a new issue of
common stock if a capital budgeting analysis (in which flotation costs are treated as
outlays) proves favorable.
10. Describe the steps in setting dividend policy based on residual dividend model.
The steps used in setting dividend policy based on residual dividend model:
a. forecast the capital investment needs over a planning horizon’ $1.5 m
b. set a target capital structure 100% equity
c. estimate the annual equity needs for capital investment $ 1.5 m
d. set target payout based on the residual model $ 2.0m -1.5 m = $0.5m
e. maintain growth rate if possible. Varying capital structure somewhat if necessary
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TUTORIAL 10 BUSINESS MERGER
1. Why does corporation carry out merger? What are the benefits of merger?
Reasons for merger
a. Economies of scale- merged company will help to reduce per unit production
cost because of larger output
b. Economies of vertical integration – takeover supplier to reduce input cost
c. Combining complementary resources- each of the firm help each other by filling
in the missing resources of the other firm
d. Merger as a use of surplus fund – company can use extra fund to take over
another company
Benefits of merger
a. Tax benefits – loss making firm combine with profit making firm to reduce
income tax payment
b. Complementary in financial slack- cash poor firm combine with cash rich
company so that the cash poor firm can use the cash to invest in positive NPV project.
c. Removal of ineffective managers-after merger, all the ineffective managers of the

target firm will be removed.
d. Increased market powers – after merger, merged company will have more
monopoly power ie more control over pricing
e. Reduction in bankruptcy costs – the combined firm will be financially stronger,

thus reduce the bankruptcy cost and risk
2. As a manager in a corporation, what are the defensive tactics you can use to prevent merger?
Refer to lecture notes for detail. Week 10

a. White knight- white knight is friendly to the target management. White knight will help
the target company by competitive bid by bidding up market price to prevent takeover.
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b. Shark repellent- prevent takeover by making amendment to company charter. Like
requiring acquirer to have 60% share instead of 51%
c. Poison pill – make the target company not attractive for takeover ie load target
company with heavy debt or give out excess cash for managers ie golden parachute.
d. White squire- a white squire is friendly to target management. The white squire will
purchase enough share of the target to block the takeover. Ie to prevent acquirer from
getting 51% share
3. Contrast spin off and carve outs.
Spin off - the process of a business separating the ongoing operations of a subsidiary unit
and giving the shareholders of the parent firm shares of the subsidiary unit. The parent and
the spin off unit are separate business entities
Carve out – similar to spin off, but the carve out unit issues shares of the new firm to the
public .
4. Describe the parties that will benefit from a merger.
a. Shareholders of the target firm – the shareholders of target firm will have greater
earning because of the competitive bid which raises the share price
b. Lawyers and brokers that carried merger – the lawyers will prepare legal documents to
support the acquisition and merger. Lawyer will have more business. Broker will be in
charge buying share on the behalf of the acquirer
c. The executives of the acquiring firm. The merger firm will become a larger business
entity and executives will have greater responsibilities which translate to greater pay
5. What are the main features of Leverage Buy Out (LBO)?
The main features of LBO, leverage buy out are.

a. Large portion of the buy out is finance by debt /borrowing
b. Shares of the LBO no longer trade on the open stock market i.e. private company
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6. Yablonski Cordage Company (YAB) is considering the acquisition of Yawitz Wire and Mesh
Corporation (YAWITZ) with common stock. Relevant financial information is as follows:
YAB YAWITZ
Present earnings (in thousands) RM4,000 RM1,000

Common shares outstanding (in thousands) 2,000 800
Earnings per share RM2.00 RM1.25
Price/earnings ratio 12 8
YAB plans to offer a premium of 20% over the market price of Yawitz stock.
(a) What is the ratio of exchange of stock? How many new shares will be issued by YAB?
(b) What are earnings per share for the surviving company immediately following the merger?
(c) If the price/earnings ratio for YAB stays at 12, what is the market price per share of the
surviving company? What would happen if the price/earnings ratio went to 11?
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1 share of YAB is RM 24 1 share of YAWITZ is RM 12
0.5 share is RM 12 is enough to pay for 1 share of YAWITZ is RM 12
0.5 X 800 000 SHARES TO PAY FOR 1 X 800 000 SHARES OF YAWITZ
400,000 X RM 24= RM 9.6 M 800,000 X RM12=RM 9.6 MILLION
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7. Oracle Berhad, a dynamic business in microchips makes a bid of 17 shares for every 20 shares of
Wizard Berhad, which manufactures electronic hardware. The income statements of the two firms
are as follows:
A concerned shareholder of Wizard Berhad believes that the bid is undervalued and asks for your
advice. You are required to determine:
(a) The bid consideration
(b) The earnings per share of the combined group.
(c) The theoretical post-acquisition price of Oracle shares assuming the price/earning ratio remains.
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17 SHARES OF ORACLES 20 SHARES OF WIZARD
17/20 SHARES OF ORACLES 1 SHARE OF WIZARD
17/20X0.5 M =425 000 0.5M =500,000
425000 SHARES X RM2 = RM850,000
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TUTORIAL 11 & 12 : THE VALUATION AND CHARACTERISTIC OF BONDS AND

STOCKS
QUESTION 1
Assume that you wish to purchase a bond with a 30-year maturity, an annual coupon rate of 10
percent, a face value of $1,000, and semiannual interest payments. If you require a 9 percent
nominal yield to maturity on this investment, what is the maximum price you should be willing to
pay for the bond?
Answers:
Coupon /interest = 10% x 1000 = $100 per annum

Semi annual coupon = $100/2 =$ 50
YTM/Required return = 9%/
Semiannual required return =9%/2 = 4.5%
Semiannual period = 30 years x 2 = 60 semiannual period
Numerical solution:
Price of bond = PMT (PVIFA 4.5% ,60) + FV (PVIF 4.5% , 60)
PVIFA = 1-1/(1+K)N / K PVIF = 1/ (1+K)N
VB = $50((1- 1/1.045 )/0.045) + $1,000(1/1.04560)
60
= $50(20.6380) + $1,000(0.071289) = $1,103.19@ $1,103
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QUESTION 2
You intend to purchase a 10-year, $1,000 face value bond that pays interest of $60 every 6 months. If
your nominal annual required rate of return is 10 percent with semiannual compounding, how much
should you be willing to pay for this bond?
Answers:
Semiannual required return =10%/2 =5%

Semiannual compounding period = 10 years x2 =20 semiannual period
Semiannual coupon = $60
PMT = ANNUITY PAYMENT
Numerical solution:
Price of bond = PMT (PVIFA i % ,n) + FV (PVIF i% , n)
VB = $60(PVIFA5%,20) + $1,000(PVIF5%,20)
= $60((1- 1/1.0520)/0.05) + $1,000(1/1.0520)
= $60(12.4622) + $1,000(0.3769) = $1,124.63
QUESTION 3
A $1,000 par value bond pays interest of $35 each quarter and will mature in 10 years. If your
nominal annual required rate of return is 12 percent with quarterly compounding, how much should
you be willing to pay for this bond?
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Answers:
Time Line:
0 3%
1 2 3 4 40 Quarters
| | | | | · · |
PMT = 35 35 35 35 35
PV = ? FV = 1,000
Quaterly required return = 12% /4 = 3%

Quarterly period = 10 years x 4 = 40 quarters
Quarterly coupon = $ 35
Numerical solution:
Price of bond = PMT (PVIFA 3 % ,40) + FV (PVIF 3% , 40)
VB = $35((1- 1/1.0340)/0.03) + $1,000(1/1.0340)

= $35(23.1148) + $1,000(0.3066) = $1,115.62.
QUESTION 4 (common stock valuation)
A share of common stock has just paid a dividend of $3.00. If the expected long-run growth rate for
this stock is 5 percent, and if investors require an 11 percent rate of return, what is the price of the
stock?
Answers:
Using Dividend Discount Model
P = D0 (1+g) / r-g D0=3, g = 5% , r= 11%
$3.00(1.05)
P0 = = $52.50
0.11 - 0.05
QUESTION 5 (preferred stock valuation)
The Jones Company has decided to undertake a large project. Consequently, there is a need for
additional funds. The financial manager plans to issue preferred stock with a perpetual annual
dividend of $5 per share and a par value of $30. If the required return on this stock is currently 20
percent, what should be the stock's market value?
Answers:
P = D0 (1+g) / r-g g=0 , D0= 5 , r = 20%
Vps = Dps/rps = $5/0.20 = $25.
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QUESTION 6 (preferred stock valuation with quarterly dividend)
A share of preferred stock pays a quarterly dividend of $2.50. If the price of this preferred stock is
currently $50, what is the nominal annual rate of return?
Answers:
Annual dividend = $2.50(4) = $10.
Vps = Dps/rps
rps = Dps/Vps = $10/$50 = 0.20 = 20%.
QUESTION 7 (common stock with perpetual constant dividend)
NoGrowth Corporation currently pays a dividend of $2 per year, and it will continue to pay this
dividend forever. What is the price per share if its equity cost of capital is 15% per year?
g=0, D= 2 r= 15%
using dividend discount model,
P = D (1+g) / r-g = 2 (1+ 0) / 15% -0 = $ 13.33
QUESTION 8
DFB, Inc., expects earnings this year of $5 per share, and it plans to pay a $3 dividend to
shareholders. DFB will retain $2 per share of its earnings to reinvest in new projects with an
expected return of 15% per year. Suppose DFB will maintain the same dividend payout rate,
retention rate, and return on new investments in the future and will not change its number of
outstanding shares.
(a) What growth rate of earnings would you forecast for DFB?
(b) If DFB’s equity cost of capital is 12%, what price would you estimate for DFB stock?
(c) Suppose DFB instead paid a dividend of $4 per share this year and retained only $1
per share in earnings. That is, it chose to pay a higher dividend instead of reinvesting in as
many new projects. If DFB maintains this higher payout rate in the future, what stock price
would you estimate now?
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Retention rate or ploughback ratio = 2/5 = 40%

Return on investment = 15%
(a) g = retention rate / plowback ratio × return on new invest

= (2/5) × 15% = 6%
using dividend discount model

D1= 3 , r= 12% , g =6%
(b) P = D1/ r-g = 3 / (12% – 6%) = $50
Earning = $5 , dividend payout =$4 retention = $1

Retention rate = 1/5 = 20%
g = (1/5) × 15% = 3%,
P = D0 (1+g) / r-g = D1/ r-g

D1= 4, g=3%, r = 12%
P = 4 / (12% – 3%) = $44.44
CONCLUSION-
HIGHER RETENTION $2, HIGHER GROWTH 6%, HIGHER

STOCK PRICE $50
LOWER RETENTION $1, LOWER GROWTH 3%, LOWER

STOCK PRICE $44.44
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TUTORIAL 12 VALUATION OF COMPANIES
1. IDX Technologies is a privately held developer of advanced security systems based in Chicago. As
part of your business development strategy, in late 2008 you initiate discussions with IDX’s
founder about the possibility of acquiring the business at the end of 2008. Estimate the value of
IDX per share using a discounted FCF approach and the following data:
■ Debt: $30 million
■ Excess cash: $110 million
■ Shares outstanding: 50 million
■ Expected FCF in 2009: $45 million
■ Expected FCF in 2010: $50 million
■ Future FCF growth rate beyond 2010: 5%
■ Weighted-average cost of capital: 9.4%
CORPORATE VALUATION MODEL
FCF = FREE CASH FLOW
From 2010 on, we expect FCF to grow at a 5% rate. Thus, using the growing perpetuity
formula, we can estimate IDX’s Terminal Enterprise Value in 2009 = $50/(9.4% – 5%) =
$1136.
Adding the 2009 cash flow and discounting, we have
Enterprise Value in 2008 = ($45 + $1136)/(1.094) = $1080.
Adjusting for Cash and Debt (net debt), we estimate an
Equity value of the firm = MV of firm + cash – MV debt =
$1080m + 110m – 30m = $1160m.
Dividing by number of shares:
Stock share = $1160m/50m = $23.20.
2. Anle Corporation has a current price of $20, is expected to pay a dividend of $1 in one year, and
its expected price right after paying that dividend is $22.
(a) What is Anle’s expected dividend yield?
(b) What is Anle’s expected capital gain rate?
(c) What is Anle’s equity cost of capital?
a. Div yld = 1/20 = 5%

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b. Capital gain rate = (22-20)/20 = 10%
c. Equity cost of capital = 5% + 10% = 15%
3. Krell Industries has a share price of $22 today. If Krell is expected to pay a dividend of $0.88 this
year, and its stock price is expected to grow to $23.54 at the end of the year, what is Krell’s
dividend yield and equity cost of capital?
Dividend Yield = 0.88 / 22.00 = 4%

Capital gain rate = (23.54 – 22.00) / 22.00 = 7%
Total equity cost of capital (expected return for investor)= rE = 4% + 7% = 11%
4. You notice that PepsiCo has a stock price of $52.66 and EPS of $3.20. Its competitor, the Coca-
Cola Company, has EPS of $2.49. Estimate the value of a share of Coca-Cola stock using only this
data.
PepsiCo P/E = 52.66/3.20 = 16.46x. Apply to Coca-Cola: share price of coca cola EPS X P/E =
$2.49 ×16.46 = $40.98.
P/E ratio = price per share / earning per share 16.46 = price /2.49 price = 2.49 x 16.46
5. Explain Efficient Market Theory.
Weak form efficiency - stock market reflect past or historical information
Semi strong form efficiency- stock market reflect public available information plus historical
information
Strong form efficiency– stock market reflect public and private information and historical
information
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TUTORIAL 13 MULTINATIONAL OPERATIONS AND

TUTORIAL 14 MANAGING FOREIGN EXCHANGE RATE RISK
1. Define Multinational Corporation.
Multinational company is a corporation that operates in two or more countries. Decision

making within the corporation may be centralized in the home country or may be
decentralized across the countries in which the corporation does business.
2. Give three reasons why do corporation expand its business in a foreign country?
Reasons why corporation seek to expand into other countries

a. To seek production efficiency- to reduce production cost eg labour cost
b. To avoid political and regulatory hurdles- to avoid government control and for
political reason eg not in good term with government
c. To seek new markets – to find overseas market for local product eg malaysian find
new market for our musang king durian and bird nest, golden dragon fish
d. To seek raw materials and new technology’ –set up factory where raw material is
available, eg set up factory in Indonesia if produce gloves because natural latex
abundant in Indonesia
e. To protect processes and products- set up business in oversea where copy right law is
enforced.
f. To diversify- to diversify business in overseas.
g. To retain customers – get close to overseas customers by setting up overseas branch

office
3. Differentiate between direct quotation and indirect quotation.
Indirect quotation – the number of units of a foreigh currency needed to purchase one US
dollar. 111.11 Japenese Yen to buy USD 1.
Direct quotation – prices of foreign currencies expressed in dollars

USD 0.009 to buy ONE JAPENESE YEN , USD 0.65 to buy ONE AUST. DOLLAR
4. What is cross rate?
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CROSS RATE IS THE EXCHANGE RATE BETWEEN TWO CURRENCIES. CROSS

RATES ARE ACTUALLY CALCULATED ON THE BASIS OF VARIOUS
CURRENCIES RELATIVE TO THE US DOLLAR
5. Define exchange rate risk.
EXCHANGE RATE RISK is the value of a cash flow in one currency translated to another
currency will decline due to a change in exchange rates
6 Explain the differences between floating monetary agreement and fixed monetary agreement.
In Floating monetary agreement, the exchange rate is determined by the market’s supply and
demand for the currency. Government may occasionally intervene and buy and sell their
currency to stabilize fluctuation
Fixed monetary agreement – exchange rate is fixed by government. No fluctuation in exchange

rate.
7 Explain the following terms:
(i) Option
(ii) Forward contract
(iii) Future contract
(iv) Swap.
a. Option - an option contract gives the holder the right but not the obligation, to buy or sell
an asset at some predetermined price within a specified period of time.
Call option contract gives the holder the right to buy asset, put option contract gives the
holder the right to sell an asset.
Eg warrant is a call option- warrant gives the warrant holder the right to buy certain number
of shares at a fixed price in the future .
b. Forward contract- in forward contract, one party agrees to buy a commodity at a specific
price on a future date and the counterparty agrees to make the sale. There is physical
delivery of the commodity
c. Future contract- a future contract is a standardized, exchange traded contract in which

physical delivery of the underlying asset does not actually occur.
d. Swap- a swap is the exchange of cash payment obligation between two parties, usually
because each party prefers the terms of the other’s debt contract.
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A has bond with fixed coupon rate. B has bnd with floating rate. A will exchange the bond
with B because A like bond with floating rate and B like bond with fixed rate
8.
The following spot rates are observed in the foreign currency markets:
CURRENCY UNITS REQUIRED TO BUY ONE US DOLLAR
Britland (ounce) 0.62

Spamany (liso) 1,300.00
Shopan (ben) 140.00
Lolland (guildnote) 1.90
On the basis of this information, compute to the nearest second decimal the number of
(a) Britland ounces that can be acquired for $100
$100 x 0.62 = 62 Britland ounces
(b) US dollars that 50 Lolland guildnotes will buy
50/1.90= $ 26.32
(c) Spamnay lisos that can be acquired for $10
$10 x 1300 = 13,000 spamany lisos
9. Briefly explain hedging risk.
Hedging is a risk management technique to reduce the uncertainty..
hedging is usually used when a price change could negatively affect a firm’s profits
long hedge involves the purchase of a futures contract to guard against a price increase. Buy a
future contract to lock in the purchase price
short hedge involves the sales of a future contract to protect a price decline. Sell a future
contract to lock in the selling price.
58

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FULL Corporate Finance Answer

Corporate Governance&Ethics (Tunku Abdul Rahman University College)

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TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

BBMF2093 CORPORATE FINANCE

TUTORIAL 1 NATURE AND SCOPE OF FINANCIAL PLANNING.

1. State the financial goal of a corporation.

ANSWER- The financial goal of a corporation is maximizing shareholders’ wealth through

2. Briefly discuss “Agency relationship”.

3. Explain the conflict of interest between shareholders and managers.

ANSWER- There is conflict of interest between shareholders and managers of

4. Explain how shareholders can reduce agency problems.

1. ANSWER- Generally there are two ways of seeking to optimise managerial

Other ways to overcome agency problem between shareholders and managers

5. Describe the three factors that affect stock price.

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TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

6. Differentiate market price and intrinsic value of common stock.

7. Briefly explain overvalued stock and undervalued stock.

8. Discuss the effects of stock price maximization to society.

c. efficient and courteous service, adequate stocks of merchandise , and well-located

9. Describe the three social responsibilities of corporation.

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TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

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TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

TUTORIAL 2 INVESTMENT APPRAISAL

1. Differentiate between independent project and mutually exclusive project.

2. Briefly explain the steps in capital budgeting process.

(a) Determine the initial capital of both projects.

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TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

YEAR CASH FLOW PVIF 12% Discounted Cash

INITIAL CAPITAL OF PROJECT A = 44.64+63.78+56.94+57.2= 222.56 M

YEAR CASH FLOW PVIF IRR=15% Discounted Cash Flow

INITIAL CAPITAL OF PROJECT B = 52.18+30.24+26.30+11.44= 120.16 M

PROJECT B NPV CALCULATION

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TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

YEAR CASH FLOW PVIF 5% Discounted Cash Flow

BTB should chose Project A due to higher NPV, compared to project B

(c) Calculate the following capital budgeting criteria of both projects.

(ii) Discount Payback Period

ii. Discount Payback Period A

ii. Discount Payback Period

Answer :Project B (IRR = 15%) > Project A (IRR = 12%)

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TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

USE NPV AS THE BETTER CAPITAL BUDGETING TECHNIQUE CAUSE NPV

Result is inconsistent between IRR and NPV

MODIFIED INTERNAL RATE OF RETURN FOR PROJECT A

YEAR CASHFLOW COMP CASHFLOW COMPOUNDED CF

222.5 = 320.08/ (1+MIRR)4

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TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

ANSWER TO QUESTION 5 (PY 2016)

Net Present Value (RM)

Discounted payback for equipment A = 4 years + 6252/34044= 4.18 years