Esc-Clermont Sup de Co

2^nd years, 1^st semester

Course : Corporate finance

Teacher : André Cabannes

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Final exam & Answers in blue

December, 2007

3 hours, 20 questions, each worth 5 points. Write your answers on this document in the blank space below each question.

Question 1: At the end of its accounting year, and after including year end adjustments, a firm has the following trial balance:

	Debit	Credit
Capital		100
Cash	10
Opening stocks (IS)	-
Closing stocks (IS)		50
Closing stocks (BS)	50
Equipment (fixed assets)	50
Mary (supplier)		-
Purchases	80
Salary	10
Sales		90
Steve (client)	40
Depreciation (IS)	10
Cumulated deprec. (BS)		10
Provisions (IS)	20
Cumulated prov. (BS)		20
Total	270	270

On the following page, establish its Income Statement, and its Balance sheet.

This question was treated in the course:

http://www.lapasserelle.com/clermont/corporate_finance/Lesson3/review.htm

1) Profit and loss account

	Debit	Credit
Sales		90
Op stocks	-
Purchases	80
Cl stocks (IS)		50
Salary	10
Dep (IS)	10
Prov (IS)	20
P&L		20

2) Balance sheet

Assets

	Debit	Credit
Equipment	50
Cum dep		10
Cl stocks	50
Clients (Steve)	40
Cum provisions		20
Cash	10
Total	150	30

Liabilities

	Debit	Credit
Capital		100
Cum P&L		20
Suppliers (Mary)		-
Total		120

Question 2: Is the asset side of the balance sheet of a firm the list of all the values today of what the firm owns? (explain)

No. The asset side does record what the firm owns, but at acquisition value, which usually is not the same as the values today. This is particularly true of land assets.

Question 3: A firm sells for 120€, cash, an item recorded at 90€ in its stocks: show the impact of this operation on the balance sheet.

Cash increases by 120€

Stocks decrease by 90€

So the asset side increases by 30€

And, on the liability side, this corresponds to an increase of 30€ in the cumulated profit.

Consider the following year end documents of a firm. Questions 4 and 5 refer to these data.

Question 4: What is the ROCE ratio in 2003 and in 2004 ?

First, let’s compute the Capital engaged :

CE2002 = 300 + 50 + 0 + 100 = 450

CE2003 = 300 + 70 + 50 + 100 = 520

CE2004 = 300 + 100 + 50 + 100 = 550

The average CE in 2003 is (450 + 520)/2 = 485

The average CE in 2004 is (550 + 520)/2 = 535

ROCE = (Result before interest and taxes)/(average CE)

So

ROCE2003 = 70/485 = 14,4%

ROCE2004 = 90/535 = 16,8%

(This was also a question treated in the course.)

Question 5: What do we mean by “this firm doesn’t use much its free financing possibilities”?

We mean that its current liabilities are “too low” compared to its current assets. In other words, the firm could have higher current liabilities (pay with a longer delay its suppliers), and reduce the amount of money borrowed from banks and bond holders, which is costly.

Question 6: What distinguishes General Accounting and Cost Accounting?

General accounting is

- Turned toward the past

- Legally required

- Must be published

- Very global

- Useless for day to day management

Cost accounting is the opposite on each criterion. It is

- Turned toward the future (used to prepare budgets)

- Not mandatory

- It is advisable not to publish it (which would be very valuable for the competitors)

- Very detailed

- Very useful for day to day management (this is why it is sometimes called “managerial accounting”)

Question 7: What is a cost center? What is a profit center?

A cost center is a small part of the activity of the firm where costs of the same nature are accumulated. Usually they are under the responsibility of a low ranking manager, or a supervisor. For instance, the “salary costs of welding in the children bike product line” is a cost center.

A profit center is a large part of the activity of the firm to which we can assign a part of the sales, and therefore of the profit (or at least of the contribution before non allocated costs).

Question 8: A manufacturer of furniture has the following income statement, split by product lines :

(It looses money.)

For what pairs of unit prices would it make money?

Exercise done in class.

Observe that the pair of prices (100, 0) turns a profit of zero.

And so does the pair (0, 400).

In a two dimensional plan with abscissa, the price of chairs, and ordinate, the price of tables, draw the line joining these two points.

Any pair of prices on or above the line, is OK.

Question 9: Why are complete unit costs artificial? Yet, why are they useful?

Complete unit costs are artificial because they encompass artificial allocations of fixed costs.

Yet, they are useful to establish a sensible price list.

Question 10: You are the general manager of firm A. You consider buying firm B. You would pay the shareholders of B a certain price, and would take over all the debts and other credits of B.

How would you approach the question of figuring how much money to pay for B?

This is akin to a physical investment. The acquisition will have an impact on our other activities. Therefore we must look at the future cash flows without the acquisition, and the future cash flows with the acquisition.

The stream of extra cash flows (estimated), properly discounted, will give an upper limit to the price to pay for B.

Question 11 : Consider a security S which can be purchased today. In one year, it will have a value X which is random (depending upon the state of the economy). The possible values of X, with their respective probabilities, are given in the following table:

Possible outcomes	90 €	100 €	110 €	120 €	130 €	140 €
Probabilities	10%	15%	25%	25%	15%	10%

If a money management fund purchases S today, for a price P, how will it record this transaction in its accounting system? (Debit and Credit.)

We debit one of the “securities accounts” of the management fund, and we credit whatever account was used to pay.

Question 12: What is the expected value of S in one year? (Explain your calculations.)

115€ (weighted average of the possible values, weighted with the probabilities)

What is the standard deviation of the value of S in one year? (Explain your calculations.)

Variance = 205 (formula: average squared deviation around 115)

Standard deviation = 14,3€ (square root of the variance)

Question 13: In the euro zone, in early December 2007, the rate of return of a risk free security is 4%. What is the price today of a risk free security that will be worth 115€ in one year?

115/(1 + 4%) = 110,58€

Is S (of question 11) risk free?

No, because the value of S next year is not fixed. It is a random variable with some variability (measured, for instance, by its standard deviation).

Question 14: Suppose S sells today for a price P = 90€. What is the expected profitability of S?

(115 – 90) / 90 = 27,8%

Question 15: What is the “risk-return graph” that helps describe a financial market?

A plot in two dimensions (with the risk in abscissa, and the expected return in ordinate) of the securities available in a given market.

Return = (Future value – Price) / Price

Risk = standard deviation of Return

Question 16: Explain the concept of present value. Use the following example: why a sum of 100€ promised in one year is not worth 100€ today? What happens to its present value if its future value is risky?

The promise, held today, to receive a certain amount of money M, in one year, has a value today, which is somewhat less than M. It depends upon the risk of M (if it is a random variable); but even the promise of sure future payments are worth less than their “face value”.

Why is that? It is so because, when we buy the promise, we give up the possibility to “make our money work” (in a physical investment for instance). So we cannot pay M (the future value) for the promise.

The more risky is the future payment M, the smaller is the price today.

This is the reasoning in the Modern Theory of Finance (i.e. the standard theory at present). It is not devoid of subtle paradoxes.

Question 17: We are considering making an investment I, which will produce the following cash flows in the future for us:

(mio euros)	year 0	year 1	year 2	year 3	year 4
Future cash flows		50	100	130	80

Suppose this investment has the same risk pattern as S above, i.e. its opportunity cost of capital is r = 27,8%. What is the Present value of the stream of future cash flows of I? (Show your calculations.)

Use the discounting formulas taught in class.

The present value of the cash flow C1 (50 in one year) is PV(C1) = 39,1

PV (C2) = 61,2

PV (C3) = 62,3

PV (C4) = 30,0

So the present value of the whole collection is: 39,1 + 61,2 + 62,3 + 30,0 = 192,6

If we can make this investment with an initial cash-flow-out of 200 millions euros to be spent year 0, is it a good investment?

No, because this is higher than the value today of what we buy (the present value of the stream of future cash flows).

Question 18 : Explain what we mean by the IRR of an investment.

For a given C0 (the initial investment we have to make to “acquire” or produce the stream of future cash flows), it is the value of the discounting factor that makes the Net Present Value equal to zero.

It is a generalisation of the concept of profitability.

Suppose we can make I with CF year 0 = 200 mio euros. What is the NPV of I, if the proper discount rate (i.e. the opportunity cost of capital) is 20%?

NPV at 20% = 24,9

What is the NPV if r = 30%?

NPV at 30% = -15,2

Estimate the IRR of I.

The exact result is: 25;8%

It can be obtained approximately using a linear interpolation between 20% et 30%.

Question 19: What is the central idea introduced by Finance which distinguishes it from Accounting?

“The time value of money”.

That is, more explicitly, the idea that a promise, held today, to receive a sum of money M in say one year, has a value today which is less than M.

This is so, because by spending money to acquire the promise, we abandon the possibility to “make it work” in a physical investment. So if we paid M, we would abandon the possibility to have more in one year.

Question 20: You have in your pocket a $1000 face value 7 year 5% coupon rate bond, that you bought two years ago. It has five years more to go. Today’s going rate for new 5 year bonds is 4%. What is the value of the bond you have in your pocket?

We must discount with 4% the five future cash flows (50, 50, 50, 50, 1050).

This yields : $1044,52