| 1. | (a) | In each of the questions given below, one out of four is correct. Indicate the correct answer (1 mark each). | 10x1 | |
| | | (i) | Which of the following statement is most correct? | (a) | Risk refers to the chance that some unfavourable event will occur and probability distribution is completely described by a listing of the likehood of unfavourable events. | | (b) | Portfolio diversification reduces the variability of returns on an individual stock. | | (c) | When company–specific risk has been diversified, the inherent risk that remains is market risk which is constant for all the securities in the market. | | (d) | The SML relates required returns to firms’ market risk. The slope and intercept of this line cannot be controlled by the finance manager. |
| | (0) |
| | | (ii) | Stock A and Stock B each has an expected return of 15 per cent., a standard deviation of 20 per cent and a beta of 1.2. The returns of the two stocks are not perfectly correlated. The correlation coefficient is 0.6. You have put together a portfolio which is 50 per cent. Stock A and 50 per cent. Stock B which of the following statements is most correct? (a)
(b)
(c)
(d) | The portfolio’s expected return is 15 per cent.
The portfolio’s beta is less than 1.2.
The portfolio’s standard deviation is 20 per cent.
Statements (a) and (b) are correct. |
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| | | (iii) | Stock A has a beta of 1.5 and Stock B has a beta of 0.5, Which of the following statements must be true about these securities? (Assume market equilibrium.) (a)
(b)
(c)
(d) | When held in isolation, Stock A has greater risk than Stock B.
Stocks B would be a more desirable addition to a portfolio than Stock A
Stock A would be a more desirable addition to a portfolio than Stock B..
The expected return on Stock A will be greater than that on Stock B. |
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| | | (iv) | There are call options on the common stock of XYZ Corporatopm. Which of the following describes best the factors affecting the value of these call options? | (a) | The price of the call options is likely to rise, if XYZ’s stock price rises. | | (b) | The higher the strike price on the call option, the higher the call option price. | | (c) | Assuming the same strike price, a call option which expires in one month will sell for a higher price than a call option which expires in three months. | | (d) | All of the answers above are correct. |
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| | | (v) | Essar Steel Ltd. uses the GAPM to calculate the cost of equity capital. The company’s capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the company’s WACC? (a)
(b)
(c)
(d) | A reduction in the market–risk premium;
An increase in the risk–free rate;
An increase in the company’s beta.
An increase in expected inflation. |
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| | | (vi) | Assume that a project has normal cash flows i.e., the initial cash flow is negative and all other cash flows are positive. Which of the following statements is most correct? (a)
(b)
(c)
(d) | All else equal, a project’s IRR increase as the cost of capital declines.
All else equal, a project’s NPV increases as the cost of capital declines.
All else equal, a project’s MIRR is unaffected by changes in the cost of capital.
Answers (a) and (b) are correct. |
| | (0) |
| | | (vii) | Which of the following statements is correct? | (a) | The NPV method assumes that cash flows will be reinvested at the cost of capital, while the IRR method assumes reinvestment at the IRR. | | (b) | The NPV method assumes that cash flow will be reinvested at the risk–free rate, while the IRR method assumes reinvestment at the IRR. | | (c) | The NPV method assumes that cash flows will be reinvested at the cost of capital, while the IRR method assumes reinvestment at the risk–free rate. | | (d) | The NPV method does not consider the inflation premium. |
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| | | (viii) | You have determined the profitability of a planned project by finding the present value of all the cash flows from that project. Which of the following would cause the project to look more appealing in terms of the present value of those cash flows? | (a) | The discount rate decreases. | | (b) | The cash flows are extended over a longer period of time but the total amount of the cash flows remains the same. | | (c) | The discount rate decreases. | | (d) | Answer (b) and (c) are correct. |
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| | | (ix) | Which of the following could explain why a business might choose to organize as a corporation rather than as a sole proprietorship or as a partnership? (a)
(b)
(c)
(d) | Corporations generally face fewer regulations.
Corporations generally face lower taxes.
Corporations generally find it easier to raise capital.
Corporations enjoy unlimited liability. |
| | (0) |
| | | (x) | The Bombay Stock Exchange is primarily (a)
(b)
(c)
(d) | A secondary market.
An organized auction market.
An over–the–counter market
Answer (a) and (b) are correct. |
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| | (b) | For each of the questions given below, one out of four answers is correct. Indicate the correct answer (1 mark each) and give your workings/reasons briefly (1 mark). | 5x2 | |
| | | (i) | The spot USD/Yen = 190 Yen and one–year forward rate of USD/Yen = 120 Yen. The prime rate in US is 15%. What should the Japanese prime rate be? (a)
(b)
(c)
(d) | 20.11%
25.22%
27.11%
29.55% |
| | (0) |
| | | (ii) | The spot USD/INR = 43.70 and six–month forward premium is 40 paise (= Rs. 0.40). The annualized forward premium will be (a)
(b)
(c)
(d) | 1.5%
1.25%
1.86%
2.5% |
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| | | (iii) | Tata Ltd. has a target capital structure of 40% debt and 60% equity for one of its new subsidiaries. The yield to maturity of the company’s outstanding bonds is 9% and the tax rate is 40%. The CFO has calculated the company’s WACC as 9.96%. The company’s equity cost of capital is (a)
(b)
(c)
(d) | 8%
10%
13%
15%. |
| | (0) |
| | | (iv) | Airtel Communications is trying to estimate the first–year operating cash flow (at t = 1) for a proposed project. The finance staff has collected the following information Project sales
Operating costs
Depreciation
Interest expenses | =
=
=
= | Rs. 1 crore
Rs. 70 lakhs (not including depreciation)
Rs. 20 lakhs
Rs. 20 lakhs |
The company faces a 40% tax rate. The project’s operation cash flow for the first year (t = 1) is (a)
(b)
(c)
(d) | Rs. 35 lakhs
Rs. 26 lakhs
Rs. 22 lakhs
None of the above. |
| | (0) |
| | | (v) | Reliance Ltd. has an ROA of 10% and a Profit Margin of 2%. The company’s total Asset Turnover is | | (0) |
| | (c) | State whether the following statements is True or False | 5x1 | |
| | | (i) | Real options are most valuable when the underlying source of risk is very low. | | (0) |
| | | (ii) | Given two mutually–exclusive projects and a zero cost of capital, the payback method and the NPV method of selecting investments will always lead to the same decision on which project to undertake. | | (0) |
| | | (iii) | A firm’s capital structure can never affects its free cash flows. | | (0) |
| | | (iv) | In a world with no taxes, MM Hypothesis shows that the capital structure of a firm does not affect the value of the firm. However, when taxes are considered, MM Hypothesis shows a positive relationship between debt and value. | | (0) |
| | | (v) | The major advantage of a regular partnership or a corporation as a form of business is that both offer limited liability that their owners, whereas a proprietorship does not. | | (0) |
