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# Practice Questions in Finance

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Part One -Please provide as much detail and information when answering the questions.
1. Explain what drives a company's return on common equity.

2. The process of discounting and compounding are related. Explain this relationship.

3. What is the major difference between a negotiated purchase and a competitive bid purchase?

4. How does a firm's tax rate affect its cost of capital? What is the effect of the flotation costs associated with a new security issue?

5. Distinguish between financial risk and interest rate risk as these terms are commonly used in discussions of cash management.

Part II: This part can be done in Excel or Word

1. You lend a friend \$15,000, for which your friend will repay you \$37,313 at the end of five years. What interest rate are you charging your "friend"?

2. The common stock of Bouncy-Bob Moore Co. is selling for \$33.84. The stock recently paid dividends of \$3 per share and has a projected growth rate of 8.5 percent. If you purchase the stock at the market price, what is your expected rate of return?

3. The target capital structure for Jowers Manufacturing is 50 percent common stock, 15 percent preferred stock, and 35 percent debt. If the cost of common equity for the firm is 20 percent, the cost of preferred stock is 12 percent, and the before-tax cost of debt is 10 percent, what is Jower's cost of capital? The firm's marginal tax rate is 34 percent.

4. If a firm buys on trade credit terms of 2/10, net 60 and decides to forgo the trade credit discount and pay on the net day, what is the effective annualized cost of forgoing the discount?

5. Mo-Lee's Sportswear is considering building a new factory to produce soccer equipment. This project would require an initial cash outlay of \$10,000,000 and will generate annual free cash inflows of \$2,500,000 per year for eight years. Calculate the project's NPV given:

a. A required rate of return of 9 percent
b. A required rate of return of 11 percent
c. A required rate of return of 13 percent
d. A required rate of return of 15 percent

Part III: This part can be done in Excel or Word

1. HBM, Inc. has the following capital structure:

Assets \$400,000 Debt \$140,000
Preferred stock 20,000
Common stock 240,000

The common stock is currently selling for \$15 a share, pays a cash dividend of
\$0.75 per share, and is growing annually at 6 percent. The preferred stock pays a \$9 cash dividend and currently sells for \$91 a share. The debt pays interest of 8.5 percent annually, and the firm is in the 30 percent marginal tax bracket.

a. What is the after-tax cost of debt?
b. What is the cost of preferred stock?
c. What is the cost of common stock?
d. What is the firm's weighted-average cost of capital?

#### Solution Preview

Practice Questions
(Note: ^ stands for raised to the power of)
Part One -Please provide as much detail and information when answering the questions.
1. Explain what drives a company's return on common equity.

We can use Du Pont Analysis for answering this question.

Return on equity (ROE) can be decomposed as follows:
ROE = Net income/Total equity
= Net income/Total equity x Total assets/Total assets
= Net income/Total assets x Total assets/Total equity
= ROA x Equity multiplier

Return on assets (ROA) can be decomposed as follows:
ROA = Net income/Total assets x Sales/Sales
= Net income/Sales x Sales/Total assets
= Profit margin x Total Assets turnover

Putting it all together gives the Du Pont identity:
ROE = ROA x Equity multiplier
= Profit margin x Total asset turnover x Equity multiplier

Return on Equity thus has three parts:

- Operating efficiency (Profit margin)

- Asset use efficiency (Total asset turnover)

- Financial leverage (Equity multiplier)

2 The process of discounting and compounding are related. Explain this relationship.
The concept of compounding is that of interest on interest. Compounding involves future value resulting from compound interest. Its compliment, discounting, is used for calculating Present value- value today of a dollar to be received in the future.
Discounting future cash flows converts them into present value dollars. Compounding present cash flows converts them into future value dollars.
Discounting is the inverse of compounding. In discounting, we divide a future cash flow by (1+r) ^n where r is the discount rate and n is the number of periods after which the cash would be received, to arrive at its present value. In compounding, we divide a present cash flow by (1+r) ^n where r is the interest rate and n is the number of periods after which the cash invested would be received, to arrive at the future value.

3 What is the major difference between a negotiated purchase and a competitive bid purchase?
In a negotiated purchase, the firm that requires funds contacts an investment banker and begins the sequence of steps that lead to the final distribution of the securities that will be offered. The price that the investment banker pays for the securities is "negotiated" with the issuing firm.
In a competitive-bid purchase, the investment banker and underwriting syndicate are selected by an auction process. The syndicate willing to pay the greatest dollar amount per new security to the issuing firm wins the competitive bid. This means that it will ...

#### Solution Summary

Answers to questions on common equity, discounting and compounding, negotiated purchase and a competitive bid purchase, cost of capital, financial risk and interest rate risk, expected rate of return, target capital structure, trade credit terms, weighted-average cost of capital.

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