FIN701 Quiz 5 Solution: Comprehensive Finance Exam Analysis

This document presents the solutions to a finance quiz (Quiz 5) from a FIN701 course, covering a range of financial concepts. The solutions include explanations for each question, addressing topics such as the ranking of securities by volatility, the calculation of weighted average floatation costs, earnings per share after stock repurchase, the impact of risk on project evaluation, the optimal capital structure and WACC, portfolio beta calculations, the benefits of diversification, arithmetic and geometric mean calculations, the effects of stock dividends, holding period return, systematic and unsystematic risk, the components of capital structure, the valuation of levered and unlevered firms, the impact of debt on earnings per share, WACC calculation, Modigliani-Miller propositions, expected return calculations under different economic scenarios, and the impact of interest rate changes on systematic risk. The solutions provide detailed calculations and reasoning to help students understand and master the financial concepts tested in the quiz.

Exam pdf 1

Exam PDF 1
Part 1: d : This is because the small stock is considered risky among the equity asset class
which is due to lack in liquidity which is followed by large cap stocks which are also volatile
being from the equity asset class. The bonds which are long term are considered to be less
volatile. Also the US t bills which has been provided in other options is relatively considered
risk free and the least volatile.
Part 2: c: To calculate the Weighted Average floatation cost the target debt to equity ratio
would be used and the calculation is below,
Debt/Total Asset * ( Cost) + Equity/ total Asset * Cost
0.45/1.45 * 6.6 + 1/1.45 * 9.5 = 0.31*6.6 + 0.689*9.5 = 2.046% + 6.545% = 8.6%
Part 3: d: The current share price is calculated which is Equity/No of shares = 17800/5000 =
$3.56.
The excess cash which is available is $1000 and the share which can be bought is = Excess
cash / Share price = 1000/3.56 = 281 Shares.
New outstanding shares after repurchase = 5000-281 = 4719 shares.
Hence the earnings per share after repurchase = Net income / New no of shares = 31200/4719
= $6.61.
Part 4: c: As the risk level of the firm might be lower, hence high risk project is discounted by
lower risk. The same happens when a low risk project is evaluated using the firm beta, it is
rejected due to the high discount factor or beta used.
Part 5: b: As the optimal WACC leads to a mix of debt and equity which lowers the WACC.

Part 6: d: As per the question A has a weight of $100 while B has a weight of $300 additional
weight is being provided by $400. Hence the value of the portfolio = Existing amount + new
amount = 400 + 400 = 800.
Beta from Stock A = 100/800*1.4 = 0.175
Beta from Stock B = 300/800*0.6 = 0.225
Hence the total beta of the portfolio = 0.175+0.225 = 0.4. However desired beta is 1.1 hence
the lag in the Beta which is 1.1-0.4 = 0.7. This would be provided by stock C since the Beta
of risk free asset is 0.
Beta from Stock C = $ weight/Portfolio Value* Stock Beta = Desired Beta
Beta from Stock C = $ weight/800* 1.6 = 0.7 = 0.7*800/1.6 = 350
Hence the amount to be invested in Risk free asset is $400-$350 = $50
Part 7: a: This is due to the diversification benefits present in the portfolio which changes
with the change of weights of the securities in a portfolio.
Part 8:b:
Arithmetic mean: Stock returns / Number of return = 4%+9%+(-6%)+18%/4 = 25%/4 =
6.25%
Geometric mean = (1+Return)^1/N = (1.04*1.09*0.94*1.18)^(1/4) = ((1.2573)^0.25)-1 =
1.0589 – 1 = 5.89%
Part 9: d: The total number of shares = 300
The stock dividend = 5%
Hence the extra additional shares received by the investor is 300*5% = 15 Shares. The new
shareholding by the investor would be 300+15 = 315 shares.

The wealth would not increase for the investor as the stock holding would increase
but the price of the shares would decrease. Hence the overall % change in wealth would be 0.
Part 10: c: The holding period return of the stock is calculated by the following formula =
( Selling Price + Dividend – Purchase Price) = (34.6+0.4+0.4+0.4+0.4 – 32.5) = $3.7
Part 11: c: The total risk of the portfolio comprises of systematic risk and the unsystematic
risk, where systematic risk reduces with the diversification of the portfolio. However, the
systematic risk does not reduces.
Part 12: c: It is the average of the different source of capital which is present in the capital
structure of the company.
Part 13: e:
First compute the value of the unlevered firm which is calculated by using the following
formula
Value of unlevered = EBIT(1-tax)/Cost of equity = 138000*(1-0.34)/0.136 = 91080/0.136 =
669705.88
Value of levered firm = Value of unlevered firm + Debt *Tax rate = 669705.88 +
(520000*0.34) = 669705.88 +176800 = 846505.88
Part 14: b: As the debt increases the interest expense for the company increases, hence it
decreases the net income for the shareholders. This increases the variability in the EPS for the
company.
Part 15: d:
Part 16: b:
First calculate the share of each source of finance or the weight of each source of finance

Equity market value = 105000 * 22 = $2310000
Preferred Share = 25000*45= 1125000
Bonds = 1500000 * 0.98 = 1470000
Total value of the company = 2310000+1125000+1470000 = $4905000
Equity Weight = 2310000/4905000 = 47.09%
Preferred Weight = 1125000/4905000 = 22.93%
Debt Weight = 1470000 / 4905000 = 29.97%
WACC is given by,
Weight of Debt*post tax Cost of debt + Equity Weight* Equity Cost + Preferred weight*
preferred Cost
29.97*(7.8*(1-0.34)) + (47.09* 12.4) +(22.93*8)
1.5428% + 5.839% + 1.834% = 9.22%
Part 17: c: This proposition is also called the irrelevance theory as it is inapplicable in real
life situation. Also it states that the capital structure has no effect on the value of the
company.
Part 18: d: It is given by the formula =(1+Return1*1+Return2*1+ReturnN)^(1/N) – 1
Part 19: e:
Recession 14.8% 1-0.2-0.55 = 0.25
Boom -4.7% 20%
Normal 6.3% 55%

Expected Return = 14.8%*0.25 + -4.7%*0.2 + 6.3% *0.55 = 3.7%-0.94%+3.465% =
6.225%= 6.23%
Part 20: e: The increase in the interest rate by the fed is going to impact all the industries in
the economy and is therefore a systematic risk.