10AMERICAN UNIVERSITY IN BULGARIA
BUS 306:CORPORATE FINANCE I
SPRING 2011, AUBG
MIDTERM EXAM 1
Name: ___________________________________ ID _________
Version 1 Solution Guide
INSTRUCTIONS:
1. You have 90 minutes to complete the exam.
2. The exam is worth a total of 100 points.
3. You may use a calculator and scratch paper sheets. You must hand in the sheets with
your exam (put your name on it).
4. Allocate your time wisely. Use the number of points assigned to each problem as your
guide.
5. In order to get full credit on the problems, you must show ALL your work!
6. You can get partial credits if you show your calculations or provide arguments to
support your answer.
7. No credits will be warded if you fail to state your assumptions or conclusions
explicitly.
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Part A: Multiple choice questions (2.5 points each, 15 points in total):
1. Which of the following statements is CORRECT?
a. One of the disadvantages of a sole proprietorship is that the proprietor is exposed to
unlimited liability.
b. It is generally easier to transfer one’s ownership interest in a partnership than in a
corporation.
c. One of the advantages of the corporate form of organization is that it avoids double
taxation.
d. One of the advantages of a corporation from a social standpoint is that every
stockholder has equal voting rights, i.e., “one person, one vote.”
e. Corporations of all types are subject to the corporate and personal income tax.
2. Which of the following statements is CORRECT?
a. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the
periods.
b. If a series of unequal cash flows occurs at regular intervals, such as once a year, then
the series is by definition an annuity.
c. The cash flows for an annuity due must all occur at the ends of the periods.
d. The cash flows for an annuity must all be equal, and they must occur at regular
intervals, such as once a year or once a month.
e. If some cash flows occur at the beginning of the periods while others occur at the
ends, then we have what the textbook defines as a ‘variable’ annuity.
3. Which of the following statements is most CORRECT?
a. The four most important financial statements provided in the annual report are the
balance sheet, income statement, cash budget, and the statement of stockholders’
equity.
b. The balance sheet gives us a picture of the firm’s financial position at a point in
time.
c. The income statement gives us a picture of the firm’s financial position at a point in
time.
d. The statement of cash flows tells us how much cash the firm has in the form of
currency and demand deposits.
e. The statement of cash needs tells us how much cash the firm will require during
some future period, generally a year or two.
4. The term “additional funds needed (AFN)” is generally defined as follows:
a. Funds that are obtained automatically from routine business transactions.
b. Funds that a firm must raise externally from non-spontaneous sources, i.e., by
borrowing or by selling new stock or bonds to support operations.
c. The amount of assets required per dollar of sales.
d. The amount of internally generated cash in a given year minus the amount of cash
needed to acquire the new assets needed to support growth.
e. A forecasting approach in which the forecasted percentage of sales for each balance
sheet account is held constant.
5. Spontaneous funds are generally defined as follows:
a. Assets required per dollar of sales.
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b. A forecasting approach in which the forecasted percentage of sales for each item is
held constant.
c. Funds that a firm must raise externally through short-term or long-term borrowing
and/or by selling new common or preferred stock.
d. Funds that arise out of normal business operations from its suppliers, employees,
and the government, and they include immediate increases in accounts payable,
accrued wages, and accrued taxes.
e. The amount of cash raised in a given year minus the amount of cash needed to
finance the additional capital expenditures and working capital needed to support
the firm’s growth.
6. If markets are in equilibrium, which of the following conditions will exist?
a. Each stock’s expected return should exceed its realized return as seen by the
marginal investor.
b. Each stock’s expected return should equal its required return as seen by the
marginal investor.
c. All stocks should have the same expected return as seen by the marginal investor.
d. The expected and required returns on stocks and bonds should be equal.
e. All stocks should have the same realized return during the coming year.
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Part B: Simple problems (8 points each, 32 in total)
7.(8 points)To complete your last year in business school and them go through law
school, you will need $10,000 per year for 4 years, starting next year (that is, you will
need to withdraw the first $10,000 one year from today). Your rich uncle offers to put
you through school, and he will deposit in a bank paying 7% interest a sum of money
that is sufficient to provide the 4 payments of $10,000 each. His deposit will be made
today (time “0”).
a. How large must the deposit be?
b. How much will be in the account immediately after you make the first
withdrawal? After the last withdrawal?
8.(8 points)Alexandra Video Product’s sales are expected to increase by 20% from $5
million in 2010 to $6 million in 2011. Its assets totaled $3 million at the end of 2010.
Alexandra is already at full capacity, so its assets must grow at the same rate as
projected sales. At the end of 2010, current liabilities were $1 million, consisting of
$250,000 of accounts payable, $500,000 of notes payable, and $250,000 of accruals.
The after tax profit margin is forecasted to be 5%, and the forecasted payout ratio is
70%.Use the EFN equation to forecast Alexandra’s additional funds needed for the
coming year.
9.(8 points)Jackson Corporation’s bonds will mature in 10 years. The bonds have a face
value of $1,000, and an 8% coupon rate, paid semi-annually. The price of the bond is
$1,100. The bonds are callable in 5 years at a call premium of 5%.
a. What is their nominal yield to maturity (YTM)?
b. What is their nominal yield to call (YTC)?
10.(8 points)You buy a share of MIT Corporation stock for $21.40, which pays a dividend
of $1.05/share. You expect it to pay dividends of $1.1070, $1.1449, and 1.2250 in Year
1, 2 and 3 respectively, and you expect to sell it at a price of $26.22 at the end of the
year 3.
a. Calculate the growth rate in dividends for the last year.
b. Assuming that the calculated growth rate is expected to continue, what is the
expected dividend yield for the same year?
c. What is this stock’s expected total rate of return at t = 3?
C. Problem solving (13 points each, 39 in total)
10.(13 points) The most recent financial statements for Maritin, Inc. are shown below:
Income Statement Balance sheet
Sales $19,200 Assets $93,000 Debt $20,400
Cost $15,550 Equity $72,600
Taxable income $3,650 Total $93,000 Total $93,000
Taxes (34%) $1,241
Net income $2,409
Assets and costs are changingproportionallyto sales. Debt and common equity do not
change. A dividend of $963.60 was paid and Maritin wishes to maintain a constant
dividend payout ratio of 0.40. Next year’s sales are projected to be $23,040. What external
financing is needed? (Note: construct the pro-forma balance sheet to find EFN).
11.(13 points)A company currently pays a dividend of $2 per share, that is, D0 = $2. It is
estimated that the company’s dividend will grow at a rate of 20% per year for the next 2
years, then at a constant rate of 7% thereafter. The company’s stock has a beta of 1.2,
the risk-free rate is 7.5%, and the market return is 11.5%. What is your estimate of the
stock’s current price? What is the stock price in one year if it appreciates with the same
rate as dividends?
12. (13 points)Consider the possible rates of return that you might obtain over the next
year under each state of the economy. You can invest in stockUand stockV.
State of Probability of Stock A Return Stock B Return
Economy State Occurring if State Occurs (%) if State Occurs (%)
Recession 0.20 7.0% -5.0%
Normal 0.50 7.0 10.0
Bull 0.30 7.0 25.0
a. Determine the expected return, variance, and the standard deviation for stockA
andB.
b. Determine the covariance and correlation between the returns of stockAand
stockB.
c. Determine the expected return and standard deviation of an equally weighted
portfolio of stockAand stockB.
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Part D: Essay question (10 points in total)
List the three forms of market efficiency according to the EMH and give examples for each
of them.
Extract from an excellent student’s answer:
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Part D: Bonus questions (2 points each, 4 in total)
1. Which of the following classes use case-based learning approach?
a. Corporate finance 1 and 2
b. Political Anthropology
c. Introduction to Music
d. Beginning Drawing
2. Who is the current chair of the Business Department?
a. Lucia Miree
b. Donald Brady
c. Steve Sullivan
d. Cy Reed
