FINC 2011 Practice Final Exam – S1 2024 Page 1 of 15
You should be able to complete this practice
final exam in 120 minutes plus 10 minutes of
reading time.
FINC 2011 Practice Final Exam – S1 2024 Page 2 of 15
Question 1 (20 marks)
Answer BOTH of the following two questions:
A) Most traditional finance theory assumes that investors behave ‘rationally’, for
example, that investors are meanvariance optimisers. How does behavioural
finance challenge this notion? Explain. (10 marks)
Solution:
Traditional finance theory suggests that investors can make choices between
different investment options using only mean return and standard deviation. And
that most investors are risk averse (that is they require higher returns to
compensate for higher risk). This approach underlies theories such as portfolio
theory and therefore models such as the capital asset pricing model (CAPM).
Behavioural finance however makes use of psychology to better understand how
investors DO actually behave. For example, behavioural finance provides
insights into ‘irrational’ behaviour such as prospecting theory, investor beliefs
about probabilities, and unconscious herding behaviour. Each of these theories
challenge the traditional view of the meanvariance optimisers.
Students should elaborate on these points to get full marks.
Mark allocation:
 3 marks for explaining how meanvariance optimisers underlies core
finance theory
 2 marks for citing an example of a traditional theory (ie portfolio theory or
CAPM)
 3 marks for explaining how behavioural finance provides alternative
theories on investor behaviour
 2 marks for citing an example of behavioural finance theory (ie prospecting
theory, investor beliefs about probabilities, and unconscious herding
behaviour)
FINC 2011 Practice Final Exam – S1 2024 Page 3 of 15
B) Explain the relationship between Markowitz Portfolio Theory and the Capital
Asset Pricing Model (CAPM) (10 marks)
Solution:
The CAPM model is derived from the assumptions that underlie portfolio theory.
The equilibrium position determined above (question iii) demonstrates that all
rational investors will hold some combination of the risk free asset and risky
portfolio M. Since risky portfolio M therefore is the market portfolio then
investors will only face MARKET RISK or SYSTEMATIC RISK. Thus, the CAPM
determines that the required return on any risky asset (that comprises part of
portfolio M) must be a function of its market risk (rather than total risk since the
unsystematic risk has been diversified away). Therefore the CAPM equation
uses only market risk.
Ri = Rf + ß (Rm – Rf)
Mark allocation:
3 marks for identifying that CAPM is derived from portfolio theory
3 marks for identifying investors in CML face only market risk
4 marks for identifying that CAPM uses only market risk to determine the
required return for individual securities
FINC 2011 Practice Final Exam – S1 2024 Page 4 of 15
Question 2 (25 marks)
START A NEW BOOKLET
Advanced Technologies Group (ATG) has performed well in recent years and financial
analyst, Mr Smythe predicts the following possible outcomes for the company next year:
State Probability Return
Very Good 0.1 30%
Good 0.3 20%
Average 0.4 10%
Bad 0.2 30%
a) Calculate the expected return and standard deviation of returns on ATG Ltd. (5 marks)
ATG data
Expected Return
7.00%
SD
19.519%
Mark allocation:
 2 marks for calculating the expected return
 3 marks for calculating the standard deviation
FINC 2011 Practice Final Exam – S1 2024 Page 5 of 15
b) Another company listed on the ASX, CDM Ltd, has been recommended by Mr Smythe.
The expected return and standard deviation of this stock is:
E(R
i
) σ
CDM 7% 6%
The correlation between and ATG and CDM = 0.9
You are considering investing in both stocks in an equally weighted portfolio. Calculate
the expected return and standard deviation of the portfolio. (10 Marks)
Solution:
CDM data
Expected Return
7%
SD
6%
Portfolio data
Expected Return
0.07
Var
0.01569519
SD
12.53%
Mark allocation:
 4 marks for calculating the expected return
 6 marks for calculating the standard deviation
c) Is the portfolio the best outcome for the investor? Explain (10 marks)
Solution:
Both securities offer the same return but ATG has a much higher standard
deviation. Therefore the inclusion of ATG in a portfolio with CDM offers a
suboptimal outcome. Here the best choice is 100% in CDM
Students should elaborate on this although given time constraints please accept
brief answers here
Mark allocation:
FINC 2011 Practice Final Exam – S1 2024 Page 6 of 15
 4 marks for comparing the portfolio to the individual security returns and
standard deviations
 6 marks for recognising and discussing that 100% on CDM is the optimal
choice
FINC 2011 Practice Final Exam – S1 2024 Page 7 of 15
START A NEW BOOKLET
Question 3 (35 marks)
Lighthouse Manufacturing Ltd (LML) is considering investing in developing a new
advanced manufacturing process for assembling lights components. This process is
similar in risk to the methods they currently use. The CEO of LML, Mr Michael Brown,
has appointed you to evaluate the proposal for the investment committee. If the project
proceeds, it is expected to have an operating life of four years before being replaced by
newer techniques.
To assist you in evaluating the project the following information has been prepared:
• The new project requires new equipment to be purchased immediately. The cost
of the new equipment is $1,250,000. The equipment can be depreciated on a
straightline basis to zero over the life of the project. The equipment is expected
to be sold for $100,000 at the end of the life of the project.
• The new project will run in a factory that has experienced a contamination
problem. Legal requirements mean that if we do not proceed with the project it
will cost the firm $400,000 in four years to clean it up. However, if we proceed
with the project we will need to clean it immediately at a cost of $300,000.
• The new project is expected to generate sales of 100,000 light components in the
first year of operation with an average selling price of $8 per unit.
• The operating costs of the project in the first year are forecast to be $5 per unit.
• Sales revenue and costs are forecast to grow in line with inflation (which is
expected to be 3% pa each year over the life of the project).
• The project requires an increase in inventories and accounts receivable of
$2 00,000. Accounts payable will increase by $100,000. Both of these changes
will be reversed at the end of the project.
• The new project requires the use of specialised equipment owned by Lighthouse
Manufacturing Ltd, but currently leased out to another firm for $120,000 per
annum before tax. The lease has 4 years remaining and if the project proceeds
the lease will need to be cancelled. There are no penalties incurred by breaking
the lease.
• Six months ago Lighthouse Manufacturing Ltd commissioned Perth Consulting
to assess the market for this new manufacturing process. The report was
delivered two months later and the figures given above are taken from that report.
Lighthouse Manufacturing Ltd paid $120,000 Perth Consulting for the report.
FINC 2011 Practice Final Exam – S1 2024 Page 8 of 15
Additional Information:
Extract from balance sheet
Liabilities
Debentures ($100 par, 8% p.a. semiannual coupon) $3,000,000
Preference Shares ($1 par, 10% p.a. cumulative) $9 00,000
Equity
Ordinary shares ($1 par) $8,000,000
• An interest payment in relation to the debentures has just been made, and they
mature in six years from today. The current yield on similar risk debentures in
the marketplace is 5.50% p.a.
• The preference shares are trading on the market at $1.30 and a dividend has
just been paid.
• Forecasts in relation to market returns are as follows: expected rate on 10year
Commonwealth Bonds = 3.50% p.a. compounded annually; expected return on
the market portfolio = 12.0% p.a. compounded annually.
• LML has an ordinary share equity beta of 1.4
• The ordinary shares of LML are trading on the market at $1.50 each.
• The company tax rate is 30%
• LML operates in a classical tax system
FINC 2011 Practice Final Exam – S1 2024 Page 9 of 15
Required:
i) What is the appropriate discount rate that should be used to evaluate the project?
Explain your decision. (10 marks)
Solution:
Price No. Mkt Value
Weights
Return
B/T
Return A/T
Debt $112.63 30000 $3,378,907.64 20% 5.57563% 3.90294%
Preference shares $1.30 900000 $1,170,000.00 7.07% 7.69231% 7.69231%
Ordinary Shares $1.50 8000000 $12,000,000.00 72.51% 15.40000% 15.40000%
Total
$16,548,907.64
WACC
12.50763312%
Mark allocation:
 1 mark for calculating the market value of the bonds
 1 mark for calculating the market value of the preference shares
 1 mark for calculating the market value of the ordinary shares
 1 marks for calculating the effective rate on bonds
 2 marks for calculating the required return on the preference shares
(div/price) – note this does NOT need to be grossed up
 2 marks for calculating the required return on the equity (using CAPM)
 2 marks for calculating the aftertax WACC (using classical tax formula)
ii) Calculate the net cash flows used to determine the NPV of the project. Present
the cashflows in a table. (20 marks)
FINC 2011 Practice Final Exam – S1 2024 Page 10 of 15
Solution:
Initial outlay $ 1,250,000.00
Cleanup costs $ 50,349.73
Initial sales 100000
Initial Selling price $8
Initial Cost of production $5
Forecast inflation 3.00%
Working Capital $ 100,000.00
Before Tax Lease Payments $ 120,000.00
Salvage Value $ 100,000.00
Year
0 1 2 5 6
Outlay $1,250,000.00
Cleanup costs $50,349.73
Revenue
$800,000.00 $824,000.00 $848,720.00 $874,181.60
Operating Expenses
$500,000.00 $515,000.00 $530,450.00 $546,363.50
Depreciation
$312,500.00 $312,500.00 $312,500.00 $312,500.00
Taxable Income
$12,500.00 $3,500.00 $5,770.00 $15,318.10
Tax
$3,750.00 $1,050.00 $1,731.00 $4,595.43
Working Capital $100,000.00
$100,000.00
A/T Lease payments
$84,000.00 $84,000.00 $84,000.00 $84,000.00
Salvage
$100,000.00
Tax on salvage
$30,000.00
Net Cash Flows $1,400,349.73 $219,750.00 $226,050.00 $232,539.00 $409,222.67
FINC 2011 Practice Final Exam – S1 2024 Page 11 of 15
Mark allocation:
 4 marks for calculating the cleanup costs ($300000($400000/((1+0.12056)^4))
 1 mark for calculating the revenue
 1 mark for calculating the operating costs
 1 marks for calculating the growth in revenue/costs
 2 marks for calculating depreciation
 2 marks for calculating the working capital outlay
 1 mark for working capital recovery in year 6
 2 marks for calculating the opportunity cost of lease
 2 marks for EXPLICITLY identifying the sunk cost
 2 marks for proper format of information in table
 2 marks for net cash flows
FINC 2011 Practice Final Exam – S1 2024 Page 12 of 15
iii) Calculate the NPV of the project. Advise whether you should recommend the
project. Explain your decision. (5 marks)
Solution:
NPV

$607,753.77
No the project should not be accepted as the NPV is negative which indicates
that taking on the project would reduce shareholder wealth by $607,753.77,
which is not consistent with the corporate objective of maximising shareholder
wealth.
Mark allocation:
 2 marks for calculating the NPV
 3 marks for rejected the project and stating it has a negative impact on
shareholder wealth
FINC 2011 Practice Final Exam – S1 2024 Page 13 of 15
START A NEW BOOKLET
Question 4 (20 marks)
Modigliani and Miller (M&M) hypothesized that both dividend policy and capital structure
policy are irrelevant in determining the value of a firm. Outline the arguments they used
to reach their positions, including the assumptions underlying those arguments. With
reference to relevant academic literature, discuss why the M&M hypotheses might not
hold in practice.
Solution:
Outline assumptions of perfect capital market (5 marks):
1. No costs of trading shares
2. No costs of issuing shares
3. All market participants have the same information
4. No personal or corporate taxes
5. Individuals borrow and lend at the same rate as the company.
Students need to be able to reproduce proofs of both dividend and capital structure
irrelevance arguments (for example those on pp. 354356 and pp .394396) OR use
their own variation on these proofs. (10 marks)
Students then need to illustrate at least one example each of how relaxing the
assumptions above might affect make dividend AND capital structure policy relevant. (5
marks)
FINC 2011 Practice Final Exam – S1 2024 Page 14 of 15
THIS IS THE END OF YOUR EXAM
FINC 2011 Practice Final Exam – S1 2024 Page 15 of 15