Rental income from excess warehouse space

Question 1 (5 marks)

Select the best answer for each of the following unrelated items.

Note:

1 mark each

a. Which of the following would be considered an opportunity cost when undertaking capital budgeting analysis?

1) Additional investment in net working capital

2) Rental income from excess warehouse space

3) Allocation of unavoidable overhead costs

4) Writedown of assets due to impairment

b. A number of challenges arise when estimating a project’s beta in order to calculate the appropriate risk-adjusted discount rate using the capital asset pricing model (CAPM) for a capital budgeting analysis. Which of the following is not one of the challenges related to the estimation of the project’s beta?

1) Historical data is usually a good predictor of future market risk.

2) The CAPM is a single-period model, and therefore unsuitable for multi-period analysis.

3) A lack of historical data means a new and unique project has no comparable information.

4) Large forecast errors can occur because of the uncertainties associated with future cash flows.

c. ZZ Ltd. intends to raise the required funds for a new project exclusively through the issuance of new long-term debt. What would the consequences be if ZZ used its after-tax cost of debt to evaluate the project, which is in the same risk class as its current projects?

1) ZZ should not finance this project using only long-term debt.

2) The project would be undervalued.

3) The project would be overvalued

4) The project would be appropriately valued because it has been financed using long-term debt.

d. Although it is difficult to determine a firm’s optimal capital structure with precision, it is possible to

identify factors that influence it. In this context, which of the following statements is true?

1) Firms with mostly intangible assets are likely to have higher debt-to-equity ratios than those with mostly tangible assets.

2) Firms with higher business risk are likely to have lower debt-to-equity ratios than firms with lower business risk.

3) Firms with low debt-to-equity ratios are more likely to raise additional financing using debt than

firms with high debt-to-equity ratios.

4) Firms with higher business risk should borrow more than firms with lower business risk.

e. When a firm pays a dividend, which of the following dates occurs before the dividend-on date?

1) The record date

2) The ex-dividend date

3) The payment date

4) The announcement date

Question 2 (10 marks)

Select the best answer for each of the following unrelated items.

Note:
2 marks each

a. The following information relates to the shares of Ancor Ltd. and Bint Inc.:

Company Expected return Beta ()

Ancor Ltd. 10.5% 1.20

Bint Inc. 7.5% 0.80

If the risk-free rate of return is 2.5% and the market price of risk is 5.5%, which of the following statements about the common shares of Ancor and Bint is true?

1) The shares of both companies are undervalued.

2) The shares of both companies are overvalued.

3) The shares of Ancor are overvalued and the shares of Bint are undervalued.

4) The shares of Bint are overvalued and the shares of Ancor are undervalued.

b. The Rial Trading Company is a Canadian exporter. It expects to receive a payment of 20 million FCU (foreign currency units) from a foreign distributor in one year. If effective annual interests rates are

2% in Canada and 5% in Foreignland, and the current spot rate of exchange is C$1 = FCU 27.6744,

how much should Rial expect to receive in Canadian dollars?

1) $688,276

2) $702,139

3) $722,690

4) $743,945

c. The current price of a common share of Gallop Ltd. is $21. Gallop declared and paid a dividend of

$1.05 per share last year, an amount that investment analysts believe will grow at an average rate of

3% for the foreseeable future. Analysts have also indicated that they believe the expected rate of return on Gallop common shares will be 14%. According to the analysts, what price will a share of Gallop common stock be trading at in one year’s time?

1) $21.00

2) $22.86

3) $23.19

4) $23.94

d. Following a substantial increase in orders for its product, SunLight Ltd. has decided to acquire an additional delivery truck, and is now trying to decide whether it should lease or purchase this truck. If the truck is leased, SunLight would be required to make annual lease payments of $55,000 at the beginning of each year over the five-year lease period. Alternatively, if purchased, the truck would cost $200,000 and have a useful life of five years, after which it would have an estimated salvage value of zero. SunLight uses a cost of capital of 11% for its capital budgeting decisions, its after-tax borrowing rate is 6%, the CCA rate on the truck is 15%, and its tax rate is 32%. Based on this information, which of the following statements is true?

1) SunLight should purchase the delivery truck.

2) SunLight should lease the delivery truck.

3) SunLight should be indifferent between purchasing and leasing the delivery truck.

4) There is not enough information to determine whether SunLight should lease or purchase the delivery truck.

e. ABC Ltd. currently has a levered beta of 1.65, and an unlevered beta of 1.10. Its capital structure consists of 60% debt and 40% equity. What is ABC’s marginal tax rate?

1) 20.00%

2) 25.00%

3) 33.33%

4) 66.67%

Question 3 (6 marks)

Answer the following three independent questions.

protect themselves against increasing interest rates

you make a profit or loss from the contract? Explain your answer.

2 c. On June 20, 2014, the price for a common share of Alpha Ltd. is $42 and the standard deviation of its continuously compounded rate of return is 0.21. Using the Black-Scholes option pricing model, determine the current value of a call option on these shares, with an exercise price of $40 and an expiry date of September 30, 2014, if the continuously compounded annual risk-free rate is 3%.

Note:

You are not required to use interpolation to determine probability results. Use the closest values in the probability table.

Question 4 (6 marks)

Answer the following three independent questions.

1½ a. When deciding whether to lease or purchase an asset, a firm will compare the cost of purchasing the

asset with the costs of leasing the asset by determining the net value to leasing (NVL). Two of the amounts that the firm might consider in determining the NVL are the CCA tax shield on the asset and the cost of repairs and maintenance. For each of these two amounts, explain the relevance to the NVL calculation, if any.

Little Co. makes its purchases on terms of 1/10, net 60. A review of the firm’s records has revealed that payments are usually made at the end of each month, an average of 15 days after the purchases are received. Purchases are made uniformly throughout the month, and Little Co. only takes advantage of the offered discount on one-third of its purchases. When asked why the firm had implemented this payment policy, the bookkeeper replied that it was simpler to pay all outstanding accounts at the end of each month rather than wait for the due date on each separate account. The bookkeeper also stated that since the bank charges 11% interest on the firm’s revolving line of credit, borrowing to take advantage of the discount on every purchase did not make sense.

(2) i) Conceptually, should Little Co. pay its accounts on day 15? Explain why or why not.

(1)

ii) Given the facts presented above, when should Little Co. pay its accounts?

1½

You are the chief financial officer of Big Cat Co. Big Cat is currently experiencing significant short- term cash flow difficulties and has decided that the best way to manage the shortfall is to delay payment to its principal supplier by 90 days. The supplier offers Big Cat terms of 2/10, net 30, and historically you have taken advantage of the discount. Management believes that it can unilaterally extend its payment period without consultation with the supplier because Big Cat represents slightly over 50% of the supplier’s business. Briefly describe the ethical issues Big Cat faces in deciding to delay payment without consulting the supplier. As CFO, what should you recommend?

Question 5 (6 marks)

Answer the following two independent questions.

4 a. ABS Coffee Exchange Ltd. runs a national chain of cafes and requires approximately 10 million

kilograms of coffee beans each year. The current spot price of coffee beans is $4.50 per kilogram and

the one-year forward price is $6.00 per kilogram. While purchasing its total requirement of 10 million

kilograms in the spot market and storing it would be impractical, ABS believes that it can rent

sufficient warehouse space to store 2 million kilograms for a year. ABS is currently able to borrow

(2) and lend at an annualized interest rate of 6%.

i) Based on the information provided above, what is the maximum annual rent that ABS should be

prepared to pay to rent the warehouse facility? Provide supporting calculations.

(2) ii) Based on the information provided above, under what circumstances would ABS be able to make an arbitrage profit? Explain the strategy ABS would have to implement to do so.

2 b. A cash budget is a planning document arrived at through a projection of future cash receipts and cash

(1) disbursements of the firm over various intervals of time.

i) Briefly explain why changes in a firm’s production levels typically do not perfectly coincide with

changes in its sales levels, and why this imperfect match affects cash management.

(1) ii) Why is it important for the financial executive to be aware of the imperfect timing match between changes in production and sales levels?

Question 6 (7 marks)

Answer the following four independent questions.

1 a. The demand for an equity security is a function of its expected return and risk. To value a security, investors follow a three-step process. In the first step, they assess the security’s risk. Identify the remaining two steps to value a security, in their appropriate order.

You are currently considering investing in the shares of two different companies, Spruce Ltd. and Oak Inc. If both stocks lie on the efficient frontier, will they have the same expected return and risk? Briefly explain why or why not.

(1) i) Briefly explain what the risk structure is and what shape it has.

(1)

ii) Briefly explain how the risk structure differs from the term structure.

Assume that an investor with a marginal federal tax rate of 29% and a provincial tax rate of 15% earns

$1,000 of investment income. How much tax would the investor pay on the $1,000 if the income was received as interest, dividend, or capital gain? Assume the marginal provincial tax rate on dividend income is 9% and the dividend income is eligible for the dividend tax credit.

Question 7 (10 marks)

Answer the following two independent questions.

4 a. You have been asked to estimate the weighted average cost of capital (WACC) for EastCoast Inc., a large transport company that has its headquarters in Halifax. To assist with your calculations, you have been provided with the following information. EastCoast’s current capital structure consists of

one long-term bond issue with a face value of $25 million, and 10 million common shares with a book value of $50 million. The bonds were issued nine years ago with an original maturity of 15 years.

They carry a coupon rate of 6% with interest paid semi-annually and are currently priced at $103.50 for each $100 face-value bond. EastCoast’s common shares have a beta of 1.25 and are currently

priced at $15 per share. Finally, flotation costs will be 4% after tax on new debt and 7% before tax on new issues of common equity. EastCoast’s marginal tax rate is 34%, the market price of risk is 5%

and the risk-free interest rate is 2.5%.

Using this information, determine EastCoast’s WACC under the assumption that it will issue new

common shares to finance future projects.

6 b. West Ltd. is currently evaluating the possibility of expanding its product line to include two new items. After conducting its capital budgeting analysis, West has decided to use a five-year planning horizon, which coincides with the useful life of the new production equipment that it will have to purchase in order to produce the new items. This new equipment will cost $5 million and will be depreciated using the straight-line method for accounting purposes, to an estimated salvage value of

10% of original cost. Starting the new product line will also require an additional investment in net working capital of $1 million that will be released at the end of the project. This equipment can be located in a section of West’s production facilities that is currently unused. For accounting purposes, the new items will be allocated 25% of the facilities’ projected costs of $500,000 per year, although the only new costs will be an increase in electricity bill of $50,000 per year. For accounting purposes, management projects that the new product will generate operating profit before interest and taxes of

$1 million in the first year, and then $2.5 million in each of the following four years.

Assume that West’s marginal tax rate is 28%, the appropriate discount rate for use in evaluating the proposal is 10%, and the applicable CCA rate on the new production equipment is 15%.Use the net present value (NPV) method to determine whether West Ltd. should expand its product line