SCHOOL OF ECONOMICS, FINANCE & MARKETING
MID SEMESTER TEST
FIRST SEMESTER 2008 – Part-time
STUDENT DETAILS (Please Print Clearly)
Family Name: ___________________________________________________________ First Name: _____________________________________________________________ Address: _______________________________________________________________ Tel. No: (BH) ___________________________________________________________ Student Number: _________________________________________________________ Date: __________________________________________________________________
Writing Time : 1 hour and 15 minutes
Reading Test : 10 minutes
This test contributes 30% towards students’ final grade.
This test consists of 2 sections: Section A (30 marks) and Section B (30 marks) All questions must be attempted.
INSTRUCTIONS TO STUDENTS
• Fill in your details in the Student Details section above. • Do not communicate, or attempt to communicate, with any other candidate. • Please refrain from any dishonest practice. This includes, but is not limited to, referring to materials that you may have on your person, referring to materials that you may have stored in your programmable calculator, etc.
• This test paper is to be handed to the test supervisor in its entirety and unfolded. • All answers must be clearly written.
• The answers to all questions must be contained within this test paper.
STUDENTS MUST SWITCH OFF ALL COMMUNICATION DEVICES.
Page 1 of 3
SECTION A - SHORT ANSWER QUESTIONS
Total for Section A – 30 marks
(6 questions x 5 marks each)
ANSWER ALL QUESTIONS
DISCUSS FULLY THE VALIDITY OF EACH OF THE FOLLOWING STATEMENTS.
“If the current stock price were greater than P 0 =
Div 1 + P 1
(1 + r e )
we would expect investors to rush in and buy it, driving up the stocks price.” The valuation model above calculates a stock’s current price by finding the present value of the future cash flows forecasted from this stock (that is all dividends to infinity). These are discounted by the cost of equity.
If P 0 is lower that the current stock price, this means the model suggests this stock is overvalued (overpriced) in the market. Hence investors would not buy this stock and the price would/should go down.
2. “Because investors are risk averse, the risk-free interest rate is not the right rate to use when converting risky cash flows across time.”
The risk-free interest rate is not the right rate to use when discounting risky cash flows not because investors are risk-averse (as otherwise all cash flows would be discounted at the risk free rate) but rather because we must be consistent with our interest rate and cash flows. The risk impounded in the interest rate must reflect the riskiness of the cash flows across time. So in summary, this consistency does not relate to how risk averse an investor is. It relates to the cash flows and discount rate.
“The yield to maturity of a bond is the discount rate that sets the future value of the promised bond payments equal to the face value of the bond.” The yield to maturity is the rate that sets the present value of the bond payments (coupon payments and face value) to the price of the bond.
1 − (1 + YTM )− n
Pr ice = CPN
(1 + YTM )
The statement tries to claim that
(1 + YTM )n − 1
FaceValue = CPN
which is incorrect!
Page 2 of 3
“For the calculation of cash flows, fixed overhead expenses should not be deducted from the project’s revenue.”
This statement is true. Fixed overheads should not be deducted from a project’s revenue because these expenses would be incurred regardless of whether the project goes ahead or not. However if there was an incremental fixed overhead that increased if the project went ahead, the extra expense should be deducted from the project’s revenue.
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